Active vs Passive Funds

What Are Active and Passive Funds?

Active and passive describe how a mutual fund decides what to buy.

• Active fund: A fund manager and research team choose securities, decide how much to hold and when to buy or sell. The goal is to outperform the scheme's benchmark after costs.
• Passive fund: The scheme replicates or tracks an index, such as a broad market index, holding the same securities in roughly the same proportions. The goal is to match the index's return, minus costs. Index Funds and Exchange-Traded Funds (ETFs) are the most common passive funds.

Under SEBI's scheme categorisation (circular dated 26 February 2026), index funds and ETFs must invest at least 95% of total assets in the securities of the index they replicate or track.

How Does It Work?

Active fund

1. The manager studies companies, sectors, interest rates and valuations.
2. The portfolio is built within the scheme's mandate (for example, minimum allocation to large caps in a large-cap fund).
3. Holdings are changed as views change.
4. Performance is judged against the benchmark. Any extra return over the benchmark is often called alpha.

Passive fund

1. The scheme picks an index to track.
2. It buys the index's constituents in their index weights.
3. When the index provider changes the index, the fund rebalances.
4. Performance is measured by how closely it follows the index, using tracking error (variability of the difference in returns) and tracking difference (the actual return gap over a period).

Practical Example

Illustrative figures only. Returns and costs are assumptions, not predictions.

Kiran has ₹3,00,000 and compares two options in the same segment of the market:

What the active fund needs to deliver: Suppose the index returns 12% in a year.

• The index fund might deliver about 12% − 0.4% = 11.6% (tracking difference of 0.4%, assuming no other tracking gaps).
• For the active fund to match that 11.6% after its 1.8% expense, its portfolio must earn 13.4% before costs, i.e. beat the index by 1.4 percentage points just to break even with the index fund.

If the active manager's portfolio earns 15% before costs, the investor gets about 13.2%, ahead of the index fund. If it earns 12.5%, the investor gets about 10.7%, behind the index fund. Assumptions: costs deducted simply from returns; taxes and exit loads ignored.

Why Is It Important?

• Costs: Passive funds have a lower expense cap: SEBI limits the base expense ratio of index funds and ETFs to 0.90%, while actively managed open-ended equity schemes can go up to 2.10% on the first ₹500 crore of assets.
• Predictability relative to the market: A passive fund will rise and fall with its index; an active fund may do better or worse.
• Manager risk: Active funds depend on the skill and consistency of the manager and process.
• Portfolio construction: Many investors combine both, for example a passive core with active satellites.

Key Features or Components

Benefits and Limitations

Active funds

• Benefits: Potential to outperform; flexibility to avoid overvalued stocks or sectors; useful where markets are less efficient.
• Limitations: Higher costs; outperformance is not guaranteed and may not persist; style or manager changes can affect results.

Passive funds

• Benefits: Low cost, transparency (you know what the fund holds), no risk of manager underperformance versus the index.
• Limitations: You get the index's full downside; no protection from expensive or concentrated index constituents; small tracking gaps; ETFs need a demat account and may trade away from NAV.

Comparison With Related Concepts

How Does It Apply to Mutual Fund Investors?

• Scheme selection: Decide whether you want market returns at low cost, or are willing to pay more for a chance of beating the market.
• Evaluating active funds: Compare returns with the benchmark over several years and market cycles, and look at risk-adjusted performance.
• Evaluating passive funds: Compare expense ratios and tracking error between funds tracking the same index. Scheme documents disclose tracking error and tracking difference for passive schemes.
• SIP and lump sum: Both active and passive funds support SIPs (index funds directly; ETFs through a broker).

Common Mistakes and Misconceptions

1. "Passive funds are risk-free because they follow the market." Correct: They carry full market risk of the index. Why it matters: A broad equity index can fall sharply.
2. "Active funds always beat index funds because experts manage them." Correct: After costs, some active funds outperform and others underperform. Why it matters: Fees are certain; outperformance is not.
3. "All index funds tracking the same index are identical." Correct: Expense ratios and tracking quality differ. Why it matters: Small gaps compound over time.
4. "Low cost is the only factor for passive funds." Correct: The choice of index matters more: a sector index behaves very differently from a broad market index. Why it matters: Pick the index that suits your goal first.

Important Terms to Know

• Index Funds: mutual funds that replicate an index.
• Exchange-Traded Funds (ETFs): passive funds traded on stock exchanges.
• Tracking Error: variability in a passive fund's return relative to its index.
• Benchmark Index: the index a scheme is measured against.
• Fund Manager: the person who makes investment decisions in an active fund.
• Portfolio Turnover Ratio: how often holdings change.
• Risk-Adjusted Performance: return earned for the risk taken.

Key Takeaways

• Active funds try to beat a benchmark; passive funds try to match an index.
• SEBI requires index funds and ETFs to invest at least 95% in their index's securities.
• Passive funds have lower expense caps (0.90% base expense ratio) than active equity funds.
• An active fund must beat its index by more than its extra cost to add value.
• Choose based on cost, goal, comfort with manager risk and the index itself.

Related Glossary Terms

• Index Funds
• Index Funds vs ETFs
• Tracking Error
• Expense Ratio
• Mutual Fund Benchmark
• Fund of Funds (FoF)

References

• SEBI circular: Categorization and Rationalization of Mutual Fund Schemes (26 February 2026)
• SEBI (Mutual Funds) Regulations, 2026 (amended up to 7 July 2026)
• SEBI Master Circular for Mutual Funds (20 March 2026)

Disclaimer

This article is for educational and informational purposes only. It is not personalised investment, tax or legal advice, and it does not recommend any specific scheme. Mutual fund investments are subject to market risks; read all scheme-related documents carefully. Rules mentioned here can change, so check the latest SEBI and AMFI updates, and consider your financial goals, risk profile and investment horizon (or speak to a qualified professional) before making any decision.

Published by FynnChintan Finserv, an AMFI-registered mutual fund distributor. Beyond Numbers. Into Opportunities.

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