When thinking about investing, the first choice many face is whether to go for an active or passive fund. Today, I want to focus on active funds because they provide a different dynamic for investors looking to beat the market, not just follow it.
What Is an Active Fund?
An active fund is a type of mutual fund or exchange-traded fund (ETF) where the fund manager actively buys and sells stocks, bonds, or other securities. Unlike passive funds, which aim to mirror a specific market index, active funds strive to outperform the index by selecting assets that the manager believes will offer higher returns.
Fund managers analyze market trends, evaluate individual companies, and make informed decisions about which investments will perform best. The ultimate goal of an active fund is to generate higher returns than the benchmark index, such as the S&P 500.
Problem: The Struggle to Outperform the Market
The idea of beating the market sounds exciting, but it’s far from guaranteed. A significant challenge for active funds is the constant need to outperform their benchmark while also justifying their higher fees. Fund managers must consistently make the right calls—buying undervalued assets and selling them when they reach their peak.
Historically, the data doesn’t always favour active funds. For example, a study from S&P Dow Jones Indices showed that in 2022, only 51% of large-cap active funds in the U.S. outperformed their benchmark over a one-year period. Over a 10-year period, that number dropped to 13%. This points to the reality that many active fund managers struggle to consistently make the right investment decisions over the long term.
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Agitation: Why Investors Still Choose Active Funds Despite the Odds
If the data suggests that many active funds fail to outperform their benchmarks over time, why do so many investors still choose them? For one, there’s the potential upside. In theory, a skilled fund manager could significantly outperform the market, giving you better returns than you’d get from a passive index fund.
This appeal is particularly strong during volatile markets. In times of economic uncertainty, having a knowledgeable manager who can make quick adjustments feels reassuring. Some investors also prefer active funds for their ability to focus on specific sectors or strategies.
For instance, if someone believes the tech industry will outperform, they might choose an active fund focused specifically on tech stocks.
Solution: How to Identify a Quality Active Fund
Despite the challenges, I believe there are ways to pick an active fund with the potential to succeed. Here’s what I look for:
Fund Manager Track Record:
A fund is only as good as its manager. Review the manager’s track record. How has the fund performed during different market cycles? A fund manager with years of experience navigating both bull and bear markets tends to be more trustworthy. For instance, Peter Lynch, who managed the Fidelity Magellan Fund from 1977 to 1990, famously generated an average annual return of 29%, far outpacing the market. His success came from meticulous research and a strategy of investing in companies he deeply understood.
Expense Ratio:
Active funds often come with higher fees due to the manager’s hands-on approach. It’s essential to evaluate whether the expense ratio—essentially the percentage of assets used to cover operating costs—is justified. Generally, I try to avoid funds with fees above 1%. According to Morningstar, the average expense ratio for actively managed funds is around 0.67%, compared to 0.13% for passive funds. These fees eat into your profits, so you want to ensure that the manager is delivering returns that justify the higher cost.
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Consistency:
While a fund’s past performance isn’t a guarantee of future success, consistency matters. Look for funds that have consistently performed well across different market conditions. Some funds have a hot streak but then falter during bear markets. Consistent performance over 5 to 10 years can be a more reliable indicator of future success.
Sector Expertise:
Some active funds specialize in specific industries or sectors. If you have a bullish outlook on a particular industry, such as technology or healthcare, a sector-specific active fund could outperform broader market funds. For example, the ARK Innovation ETF, an actively managed fund focused on disruptive technology, saw tremendous returns in 2020, outperforming many broader index funds. However, it also faced sharp declines afterwards, underscoring the volatility in niche sectors.
What Are the Benefits of Active Funds?
1. Potential for Higher Returns:
While it’s true that many active funds don’t beat their benchmarks, the ones that do can offer significant returns. If you pick a successful fund, you could enjoy higher growth compared to simply tracking the market.
2. Flexibility in Changing Markets:
Active fund managers can adjust their strategies based on market conditions. This flexibility allows them to capitalize on opportunities or avoid potential pitfalls. For example, during the 2008 financial crisis, some active managers shifted their portfolios to more defensive stocks, helping protect their investors from the worst of the downturn.
3. Targeted Investment Strategies:
Active funds can focus on specific strategies, such as growth, value, or sectors like renewable energy or tech. If you’re interested in a particular investment thesis, an active fund might offer a way to leverage that idea.
Are Active Funds Right for You?
Deciding whether an active fund is right for your portfolio depends on your investment goals, risk tolerance, and belief in the ability of fund managers to outperform the market.
If you’re confident in a manager’s expertise and strategy, and you believe in their ability to navigate market fluctuations, an active fund might make sense. On the other hand, if you’re looking for a lower-cost, less risky option, passive funds may be more aligned with your goals.
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Conclusion: Balancing Risk with Opportunity:
Active funds can offer more control and potential for higher returns, but they also come with higher risks and fees. By carefully evaluating a fund manager’s track record, sector focus, and consistency, you can identify opportunities where active management may be worth the extra cost.
Before committing to an active fund, I recommend doing thorough research to ensure it aligns with your long-term financial objectives. While beating the market is no easy task, it’s not impossible, especially if you pick the right fund and stay patient.
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Disclaimer:
All the information in the blog is for educational purposes only. I am not a SEBI registered advisor, Please consult with a qualified financial planner or do your own research before making any investment.
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FAQ
What is meant by active funds?
The job of an active fund manager is to pick and choose investments, with the aim of delivering a performance that beats the fund’s stated benchmark or index. Together with a team of analysts and researchers, the manager will ‘actively’ buy, hold and sell stocks to try to achieve this goal.
Which is a passive fund?
A passive fund is an investment vehicle that tracks a market index, or a specific market segment, to determine what to invest in.Â
Why choose active funds?
As well as a larger investment universe, active managers can choose how much to invest in a particular company, unlike passive funds where holding size is dictated by a company’s market capitalisation.
Are active funds risky?
Active Funds: Higher risk due to reliance on the fund manager’s decisions and market timing.
What is the full form of NAV?
NAV stands for Net Asset Value.
What is active and passive money?
Active income, generally speaking, is generated from tasks linked to your job or career that take up time. Passive income, on the other hand, is income that you can earn with relatively minimal effort, such as renting out a property or earning money from a business without much active participation.
Which is better index fund or active fund?
Expense ratio:Â Index funds typically offer lower expense ratios compared to active funds. This is because index funds do not incur the costs associated with active management, such as research expenses and high portfolio turnover.
