When you are investing in mutual funds, it is crucial to choose the right one. The choice of the fund can impact your returns in a significant way. Probably, you categorize the funds in 2 categories, which are passive index funds and actively managed funds. If you are unclear about them, we will help you today. We will discuss the pros and cons of both funds and help you understand why index funds are better.
Passive Index Funds:
Let us start with the pros and cons of passive funds.
Pros:
- Low cost:
The expense ratio of passive funds is on the lower side. They do not churn their portfolio significantly. Their expense ratio is around 0.1%. It means you do not have to incur significant costs because of the fund’s management.
- Long-term results:
The index funds mimic the returns of the index. That is why such funds can provide you with long-term gains. If you are a long-term investor, these are the best funds.
- Simple methodology:
There are no complicated algorithms or strategies at work regarding passive funds. They mimic the index in their portfolio holding. The simple methodology helps you understand your fund’s investments. There is no confusion at all. It is one of the strengths of the passive index funds.
Cons:
Let us now look at some of the drawbacks.
- Stock Concentration:
Such funds have often been invested in the top 50 or 100 stocks. Owing to this very reason, they usually have a high concentration of such stocks. While it might not hamper the results in the long term, it is certainly a con that they have to deal with.
- Limited Returns:
Passive funds provide the return as per the index. Therefore, they do not beat the market because they precisely mimic the market’s returns.
Actively Managed Fund:
We will now highlight the pros and cons of actively managed funds.
Pros:
- Flexibility:
Actively managed funds have complete flexibility to invest in a broad basket of stocks. They do not just have to stick to a particular index.
- Tax Breaks:
Many high-net-worth investors invest in actively managed funds because when they incur a loss, they can easily get a tax break on it. It might not happen yearly, but it happens once in a few years because they invest in it.
Cons:
- Human Error:
There is a high probability of human error in actively managed funds. This is because the fund manager can easily go wrong with the choices of stocks in their portfolio.
- Minimum Thresholds:
Most of these fund managers have a minimum threshold. That is why it is not suitable for small investors.
- Higher Cost:
The expense ratio of actively managed funds is on the higher side. This is due to the churning of the portfolio. It limits your returns to a certain extent.
Now that you know the pros and cons of passive and actively managed funds, we will help you understand why passive index funds are a better choice.
Why are passive index funds better?
One of the main reasons passive index funds are better is that they often outperform actively managed funds over a more extended period. Index funds outperform managed funds because they do not try to time the market and stick to their investments until the stock is in the index. That is why they can capture the entire upside. Moreover, since the expense ratio is on the lower side, the returns are on the higher side.
So, if you’re considering investing, choosing passive index funds is a good idea. When you compare the pros and cons, passive funds certainly provide you an advantage.