Active vs. Passive Funds: A Comprehensive Guide for Indian Investors

Investors in India often face a tough choice between active and passive fund management. Understanding these options is crucial for making informed investment decisions. This article will clarify the key differences between active and passive funds, discuss SEBI regulations on portfolio managers, and offer guidance on choosing the right investment strategy.

Active funds are managed by professionals who aim to outperform market indices. Investing in active funds means accepting a higher level of risk, but it also opens the door to potentially higher returns. While actual examples are not specified, the success of many actively managed funds over time highlights this risk-return dynamic.

Active fund managers use various strategies to select stocks. They analyze market trends, economic indicators, and individual company performance to make investment decisions. The goal is always to beat benchmarks, which involves more research and market insight than passive strategies.

Because of the active management involved, expense ratios for these funds are typically higher than for passive funds. Investors must weigh the cost of these fees against the chance of achieving higher returns. Sometimes, investing extra for better management pays off, but it can also be a gamble.

Understanding Passive Funds 

Index Tracking and Replication

Passive funds focus on replicating the performance of specific market indices. For example, a Nifty 50 index fund invests in the same stocks as the Nifty 50 index in the same proportions. This approach means that there’s no attempt to outperform the market, making it straightforward and efficient.

While passive funds are generally less risky, they tend to offer lower returns compared to actively managed alternatives. The performance of these funds directly correlates with the underlying index. Therefore, if the index performs well, so do the funds; if not, the same applies.

A primary advantage of passive funds is their lower expense ratios. Without the costs associated with active management, these funds allow investors to keep more of their returns over time.

The Securities and Exchange Board of India (SEBI) prohibits portfolio managers from investing in unlisted securities within discretionary portfolio management agreements. This regulation is designed to protect investors from high-risk assets, which can lead to significant losses.

This rule enhances transparency, ensuring clients know where their money is invested. Unlisted securities often come with high risks, limited liquidity, and lack of transparency. By avoiding these, SEBI aims to reduce potential losses for investors.

Consider a client who entrusts a portfolio manager with ₹1 crore. If that manager invests in an unlisted startup, the client may face significant valuation uncertainties and lack clear visibility into that investment. This could lead to losses, especially considering that many startups fail.

SEBI has set a limit on operating expenses for portfolio management services (PMS) at 0.5% per annum of the client's average daily assets under management (AUM), excluding brokerage fees.

Operating expenses can include research fees, custody charges, and administrative costs. It's important for clients to understand these charges separately from brokerage fees to have a clear picture of their total investment costs.