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Passive Managed Funds: – Passive management is the strategy where the investments follow a particular benchmark index with the mindset of reflecting the benchmark’s return over a similar period of the investment horizon. This fund replicates the transaction in regard to constituents of the benchmark that are in context to the index weightage and methodology. The general belief is that markets are not mispriced and it is impossible to capture excess returns without taking an additional risk. Passively managed funds have lower management fees and transaction costs than Active managed funds.
However, it is observed that when any small cap stock does well and gets significantly re-rated then it comes into passive funds and hence the big portion of rerating and value creation is actually lost as the real earning growth trajectory is not captured by passive funds.
Active managed Funds: – Active management is the strategy of an investment fund managed by a qualified fund manager or investment advisor who makes the decision on buying and selling the particular companies in the portfolio and generates a return higher than the benchmark. A really good active fund manager typically identifies a growth company at a very early stage before it comes into the eyes of the passive fund manager and generates alpha returns during that initial rerating phase.
Why active management is important
- Invest in High conviction ideas: – Actively managed funds invest in high-conviction ideas and mispriced companies in the portfolio. Passive managed funds do benchmark hugging which means low alpha and low operating cost. So actively managing funds get higher risk-adjusted returns over a longer period of time
- Margin of safety: – There will always be a Margin of safety at the time of buying in an actively managed fund because the fund manager has to go through the fundamentals of the company. So, they are more value-conscious and hence provide a better margin of safety to the portfolio. The core reason behind any investment is to buy a stock where the intrinsic value of the business is much higher than what is perceived by the market. If the difference is higher, the active fund manager will grab the opportunity whereas a passive fund manager will attempt at replicating the benchmark without considering the disparity in pricing and thereby compromise the margin of safety rule of investing.
- Flexibility to make decisions: – Active management strategy offers sector and market cap agnostic approach. While passive funds generally follow a benchmarks-driven approach. Active fund managers enjoy the flexibility to make any decision i.e. either to hold cash, buy, or trim position in the portfolio while the passive fund management strategy uses buy at any cost.
- Timing of buying and selling: – In active funds, the fund manager can allocate a portfolio as per the conviction and general outlook of the company but in passive funds, the fund manager has to allocate funds at the time of inflows irrespective of the market levels.
- Outperform the market: – Actively managed funds have the potential to outperform the market, while passively managed funds have the potential to match the returns of the market.
Conclusion: – In actively managed funds, there are both information and analytical advantage that creates alpha. The passively managed funds do not have many advantages, especially in a weak market. However, both have their own pros and cons so one must prudently evaluate before investing in any of the strategy.
Authored by: Mr. Ishan Thakkar, Fund Manager, Fort Capital