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 not clear about them, we will help you out today. We will discuss the pros and cons of both of these funds and also 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 that you do not have to incur significant costs because of the management of the fund.
- 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 to choose.
- Simple methodology:
There are no complicated algorithms or strategies at work when it comes to 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:
The investment of such funds has been often in the top 50 or top 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, but it is certainly a con which they have to deal with.
- Limited Returns:
Passive funds provide the return as per the index. Owing to this very reason, they do not beat the market because they precisely mimic the returns of the market.
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 every year, but it happens once in a few years due to which they invest in it.
Cons:
- Human Error:
There is a high probability of human error in actively managed funds. It 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. It is due to the churning of the portfolio. It limits your returns to a certain extent.
Now that you are aware of the pros and cons of passive index funds and actively managed funds, we will help you understand why passive index ones are a better choice.
Why are passive index funds better?
One of the main reasons why passive index funds are better is because, over a more extended period, they often outperform the actively managed funds. The reason why index funds outperform managed funds is 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 thinking of investing, it is a good idea to choose passive index funds. When you compare the pros and cons of both, the passive funds certainly provide you an advantage.