Passive or Active? Decoding India’s Evolving Fund Strategies

What is an Actively Managed Portfolio?

An actively managed portfolio is a type of investment strategy where a fund manager is deeply involved in selecting and managing assets. Through meticulous research, analysis, and market forecasting, the fund manager actively makes decisions on which securities to buy, sell, or hold in the portfolio. This process aims to outperform the market benchmark, maximising returns and generating alpha for the investors.

Active management is commonly found in various investment vehicles, such as equity, debt, hybrid funds, and fund of funds. A key advantage of actively managed portfolios is the potential to achieve higher returns than the market index by leveraging the fund manager's experience, expertise, and insights. However, the drawback lies in the higher fees and expenses associated with active management, as well as the inherent risks from human decision-making.
 
 

What is a Passively Managed Portfolio?

Passively managed portfolios follow a different philosophy from active management. In this approach, the investment strategy is to mirror a specific market index's performance, rather than attempting to outperform it. Passive investments include vehicles such as index funds, exchange-traded funds (ETFs), and some funds of funds.

In a passively managed portfolio, the fund manager's role is minimal, as the fund's composition and asset allocation are predetermined by the underlying index. For instance, an ETF tracking the S&P 500 will hold the same stocks in the same proportions as the index itself. The fund manager's primary responsibility is to ensure the portfolio remains aligned with the index.

Passively managed portfolios offer some benefits over actively managed ones, such as lower fees and expenses due to the minimal involvement of the fund manager. Additionally, these portfolios reduce the risks associated with human error in decision-making. However, passively managed funds typically generate returns that are in line with the benchmark, meaning they may not outperform the market or achieve significant alpha.

How Do Fund Managers Handle Actively Managed Funds?

In India, actively managed funds are helmed by experienced fund managers who employ rigorous fundamental and technical analysis to identify undervalued or promising securities. These professionals continuously monitor macroeconomic trends, sectoral shifts, corporate earnings, government policies, and global events to make tactical buy, hold, or sell decisions. Unlike passive funds, active managers seek to outperform benchmark indices such as the Nifty 50 or Sensex by selectively investing in stocks that they believe will generate superior returns.

A key element in active management is the ability to exploit market inefficiencies—something still prevalent in emerging markets like India, where information asymmetry and liquidity constraints create opportunities for alpha generation. Managers often adopt bottom-up stock picking, combining qualitative factors such as management quality and competitive positioning with quantitative metrics including valuation ratios and earnings momentum.

However, active fund management also involves higher costs. Fund managers charge a premium for their expertise and incur transaction costs from frequent portfolio churn. Moreover, the risk of underperformance relative to the benchmark exists if the manager’s insights fail to materialise or if market movements negate their strategy.
 

How Do Passive Managed Portfolios Work?

Passive funds, increasingly popular in India over the last decade, replicate the composition of an index rather than attempting to beat it. These are commonly termed index funds or exchange-traded funds (ETFs). The fund manager’s role is primarily administrative: to ensure the portfolio mirrors the index’s stock allocation precisely and to rebalance as the underlying index changes.

In the Indian context, passive funds often track benchmarks like the Nifty 50, Nifty Next 50, or sectoral indices such as Nifty Bank. The advantage lies in simplicity and transparency. Since the fund simply follows the market, costs are significantly lower, both in terms of management fees and transaction expenses.

Importantly, passive funds leverage the concept of market efficiency, assuming that it is difficult to consistently outperform the market after costs. For investors seeking steady returns aligned with broad market performance, passive investing offers an efficient, cost-effective alternative.
 

Active vs passive funds: Differences between the two

Things to Consider Before Investing in Passive or Active Funds

Market Efficiency in India

Unlike developed markets such as the US or UK, India’s markets are still maturing. This implies that active management has the potential to generate alpha due to information asymmetry and market inefficiencies, especially in mid-cap and small-cap segments. However, this is not guaranteed and requires selecting a skilled fund manager.

Cost Sensitivity

Indian investors are becoming more cost-conscious. With the rise of low-cost platforms and robo-advisors, passive funds are an attractive proposition for cost-sensitive retail investors who prioritise long-term wealth accumulation with minimal drag on returns.

Investment Horizon and Risk Appetite

For those with a longer time horizon and lower risk tolerance, passive funds can provide steady returns in line with the market. Conversely, active funds suit investors with higher risk appetite willing to weather volatility for potential outperformance.

Fund Manager’s Track Record

Given the variability in fund manager skills in India, it is crucial to assess historical performance, consistency, and investment philosophy before choosing active funds.

Regulatory Environment

SEBI has recently enhanced regulations promoting greater transparency and fair valuation practices, influencing fund manager behaviour. Passive funds’ inherent transparency appeals to investors wary of hidden costs and opaque strategies.
 

Pros and Cons: Active vs Passive Investing

Active vs passive funds: What to choose?

When comparing passive funds vs active funds, one should consider their risk tolerance, investment goals, and the time they can dedicate to managing their investments. Both approaches have their merits, and a well-balanced investment strategy could include a mix of active and passive funds for optimal diversification.

Investors seeking higher returns and willing to take on additional risk may lean towards active funds. They can benefit from the expertise of a fund manager who actively seeks investment opportunities and adjusts the portfolio based on market conditions. Conversely, those seeking a lower-cost, lower-risk investment strategy that closely tracks the market may prefer passive funds.
 

Conclusion

Ultimately, the decision between passive funds vs active funds depends on an investor's unique financial situation, goals, and investment philosophy. Active investing offers the potential for higher returns and flexibility, while passive investing provides a cost-effective, lower-risk strategy with consistent market returns.

The optimal investment strategy will depend on your individual financial goals, risk appetite, and investment horizon. A combination of both active and passive funds can help create a well-diversified portfolio, capable of navigating various market conditions and meeting your long-term financial objectives.

Before making any investment decisions, it is essential to conduct thorough research and, if necessary, consult with a financial advisor to ensure your choices align with your financial goals and risk tolerance. By carefully considering your options and creating a tailored investment plan, you can work towards achieving financial success and a secure future.