Active & Passive Investment Strategies

29th June 2021 0 By indiafreenotes

Active Investing

Active investing, as its name implies, takes a hands-on approach and requires that someone act in the role of a portfolio manager. The goal of active money management is to beat the stock market’s average returns and take full advantage of short-term price fluctuations. It involves a much deeper analysis and the expertise to know when to pivot into or out of a particular stock, bond, or any asset. A portfolio manager usually oversees a team of analysts who look at qualitative and quantitative factors, then gaze into their crystal balls to try to determine where and when that price will change.

Active investing requires confidence that whoever is investing the portfolio will know exactly the right time to buy or sell. Successful active investment management requires being right more often than wrong.

Pros of Actively Managed Funds

Alpha generating funds: If the investor wants a bit extra than what the benchmarks are offering, then actively managed funds are better. The main objective of actively managed funds is to beat the returns of the Sensex and Nifty and generate ‘alpha’. Here the fund manager uses his/her experience, knowledge and time for market research.

Flexibility: Active managers aren’t required to follow a specific index. They can buy those “diamond in the rough” stocks they believe they’ve found.

Hedging: Active managers can also hedge their bets using various techniques such as short sales or put options, and they’re able to exit specific stocks or sectors when the risks become too big. Passive managers are stuck with the stocks the index they track holds, regardless of how they are performing.

Tax management: Even though this strategy could trigger a capital gains tax, advisors can tailor tax management strategies to individual investors, such as by selling investments that are losing money to offset the taxes on the big winners.


Expensive: Naturally every good thing in life comes at a cost and so is the expertise of a fund manager. Investors will have to pay charges (namely expense ratios) for the fund manager’s expertise and decision making.

Risk: Actively managed funds seek to generate higher returns and hence the risk associated with them is also higher than passive funds. This is because man-made decision-making processes may be prone to error.

Passive Investing

If you’re a passive investor, you invest for the long haul. Passive investors limit the amount of buying and selling within their portfolios, making this a very cost-effective way to invest. The strategy requires a buy-and-hold mentality. That means resisting the temptation to react or anticipate the stock market’s every next move.

The prime example of a passive approach is to buy an index fund that follows one of the major indices like the Nifty 50/Nifty next 50/Nifty100. Whenever these indices switch up their constituents, the index funds that follow them automatically switch up their holdings by selling the stock that’s leaving and buying the stock that’s becoming part of the index. This is why it’s such a big deal when a company becomes big enough to be included in one of the major indices: It guarantees that the stock will become a core holding in thousands of major funds.

When you own tiny pieces of thousands of stocks, you earn your returns simply by participating in the upward trajectory of corporate profits over time via the overall stock market. Successful passive investors keep their eye on the prize and ignore short-term setbacks even sharp downturns.

Pros of Passively Managed Funds

Cheaper: Their expense ratios are way lower than active funds. According to Sebi regulations, the expense ratio for ETFs cannot exceed 1%. The expense ratio for the earlier example we took, the HDFC Sensex Fund is hardly 0.05% as on May 11.

Cons of Passively Managed Funds

Cannot beat benchmarks: Such funds have moderate returns. Returns may be equal to the benchmark’s returns or lesser. They may be cheaper but do carry some charges which may lower the returns but marginally.

Other Funds

ETFs are a slight variation of the index fund. Like an index fund, the ETF also creates a portfolio of index stocks in the same proportion. The only difference is that the ETF is listed on a stock exchange and can be bought and sold on any recognized stock exchange. When you buy or sell an ETF, it only leads to transfer of ownership and not to shift in the AUM of the ETF. Additionally, ETFs are also available on other benchmarks like ETFs on gold, ETFs on silver, ETFs on equity indices, ETFs on debt market indices etc. ETF units can be bought and sold through your existing equity trading account and can be held in your regular demat account.

There is a slight variation of passive investing which entails buying and holding a portfolio of dividend yield stocks. Dividends are tax-free in the hands of the investor up to a limit of Rs.1 million per year. Thus a stock that offers a dividend yield of 6% will actually be paying an effective tax- adjusted return of {6%/(1-0.3)} = 8.57%. Most high dividend yield stocks are saturated stocks and hence the volatility risk is quite low in such stocks.