If you want to invest in the markets, but don't want your investment to dip below market returns, then you must know the difference between 'active' and 'passive' investing.
A decision that investors need to make when choosing a mutual fund, after narrowing down on the asset class, is whether to follow an active or passive investment style.
Upfront, there are two aspects worth pointing out -- the debate on active versus passive is not as pronounced in India as it is in the US. Secondly, in the more developed markets, the lines between between active and passive investing are increasingly blurred by innovations such as smart beta.
Over here, we just look at the basics -- what is active and passive investing.
Actively managed funds are those where the fund manager decides which stocks to buy and when to buy or sell them. It also means that the fund manager tactically manages the portfolio. So when s/he sees upside in a sector, s/he may move into that or exit it altogether if s/he is of the opinion it could crash.
Since the aim of active management is to deliver a return superior to the benchmark, an actively managed fund offers the potential for much higher returns than the benchmark, providing the fund manager gets her/his calls right. If not, the downside could be much higher too.
In the case of passive investing, the fund simply tracks the benchmark. The fund manger invests in the identical sectors and stocks, with similar allocations, to those of the benchmark.
The most common passive investment is an index fund. This is a fund that attempts to replicate the performance of a given index by duplicating its composition.
For instance, HDFC Index Nifty tracks the Nifty and the portfolio consists of the 50 stocks that comprise the Nifty. While HDFC Index Sensex tracks the Sensex and its portfolio comprises of the 30 Sensex stocks.
Some index funds don't duplicate the benchmark completely. For instance, HDFC Index Sensex Plus aims at investing 80-90 per cent of the net assets into stocks which comprise the Sensex, while the balance is left to the discretion of the fund manager.
A regular fund on the other hand will have the fund manager researching and picking stocks s/he believes have great upside. S/he will not restrict herself/himself to the universe of the benchmark stocks, as in the case of an index fund.
An exchange traded fund, or ETF, also falls in the passive investing category. Such a fund owns the underlying assets (stocks or gold) and divides ownership of those assets into shares.
For example, a Gold ETF will buy actual gold. It is for this reason that it serves as a proxy to investing in gold. Or, for instance, iShares, the world's largest ETF provider, has an ETF called iShares India 50 ETF which tracks the S&P CNX Nifty Index.
In the case of an index fund, you can buy the units from the asset management company, or AMC, and sell them back to the AMC, based on the current net asset value, or NAV. In the case of an ETF, the units are listed and traded on the stock exchange. Which means that investors need to have a demat account to buy and sell ETFs.
Unlike an index fund where the NAV is declared end of the day, an ETF could experience price changes throughout the day, depending on demand for the product. Worth noting is that liquidity is low for such products, so in reality that will not be the case.
As an investor, if you want to play it safe to some extent, you could choose to have a passive fund as a core holding and other actively managed funds as non-core holdings.
Or, if you are just starting out as an equity investor, you could start with a passive fund. Such a fund would target the first-time investor -- one who has no idea as to how other funds are positioned and how to select one from the hundreds available. Alternatively, if you are sure of yourself, you could do away with passive funds altogether and just go with actively managed funds.
If you want to participate in the stock market, but don't want your investment to dip below market returns, then passive investing too is an option.
As you can see, there is no right or wrong. It's what suits your profile and expectations.
On a final note, passive investing costs less than active investing.
To use the earlier examples, the expense ratios of HDFC Index Nifty and HDFC Index Sensex are 0.56 per cent and 0.49 per cent, respectively.
It goes up to 1.06 per cent in the case of HDFC Index Sensex Plus to account for some amount of active investment.
In the case of pure active funds, the expense ratio can go up to 2.5 per cent.
Photograph: Chris Potter/Creative Commons