Understanding active funds: Meaning, types, benefits

Just like a seasoned adventurer equipped with tools and supplies can tackle uncertain terrains, active funds navigate the dynamic markets through strategies that have the potential to generate alpha for investors. Thus, active funds map out opportunities and allow investors to actively engage with the market.

In this article, we will unveil the concept of active funds, explore their different types, check out their benefits, and discuss the essential factors to consider before investing in them.

What are active funds?

Active funds, also known as actively managed funds, are investment vehicles where professional fund managers actively select and manage a portfolio of securities. Unlike their passive counterparts (index funds or exchange-traded funds), active funds don’t simply mimic the performance of a particular market index. Instead, they engage in active decision-making and strive to outperform the market through the experience of a fund manager.
Therefore, active fund managers monitor and adjust the fund’s holdings with the aim of seizing market opportunities as they arise. The main objective of fund managers is to work towards maximising returns for investors.

How do active funds work?

When you invest in an active fund, your money is pooled with that of other investors. The fund manager then invests this money in a mix of shares, bonds or other securities, depending on the fund’s objective.

The process may involve:

• Conducting research on companies, sectors and the broader economy.
• Selecting securities that align with the scheme’s investment objective.
• Monitoring the portfolio regularly and making changes when required.
• Managing risk through diversification and portfolio allocation, in line with the scheme’s mandate.

The fund’s returns depend on how these investments perform after costs are deducted. Its performance is usually compared with a relevant market benchmark.

Past performance may or may not be sustained in future.

Types of active funds

Active funds comprise various categories, each with its own unique characteristics and investment strategies. Let us explore some types of active funds:
Equity funds: These active funds focus primarily on investing in stocks – for example, large-cap funds, mid-cap funds or small-cap funds. They can further be categorised based on the investment style, such as growth funds that seek companies with high potential for future expansion, or value funds that target undervalued stocks with the expectation of future growth.

Bond funds: Bond funds invest in fixed-income securities, such as government or corporate bonds. These funds aim to provide a steady flow of income and can be tailored to suit different risk appetites, ranging from conservative to more adventurous.

ELSS funds: These are Equity‑Linked Saving Schemes that invest at least 80% of their assets in equity and equity-related securities. Under Section 80C of the Income Tax Act, 1961, you can claim a tax deduction of up to ₹1.5 lakh on investments in ELSS, but only if you’re using the old tax regime. ELSS investments come with a 3-year lock-in period, even for SIPs, each installment is locked in separately for three years from its investment date.

Sector funds: These active funds concentrate their investments in specific sectors, such as technology, healthcare, energy, etc. The minimum investment in equity and equity-related instruments of a particular sector/particular theme is 80% of total assets. Sector funds allow investors to capitalize on opportunities within targeted industries, offering the potential for focused growth.

Passive investing vs active investing

Active management is one of two portfolio management styles, the other being passive management. Here’s a look at the difference between the two.

ACTIVE INVESTING	PASSIVE INVESTING
Involves active selection of securities by a fund manager or investment team.	Seeks to replicate the performance of a specified market index by investing in the same securities in a similar proportion.
The portfolio may be rebalanced based on research, market conditions and the scheme’s investment objective.	Portfolio changes are primarily made to reflect changes in the underlying index.
Performance depends on factors such as security selection, asset allocation, market conditions and fund expenses.	Performance generally aims to track the chosen index, subject to tracking error and expenses.
Typically has a higher expense ratio because of active research and portfolio management.	Typically has a lower expense ratio than active funds because portfolio management is largely index-based.
There is no assurance that the fund will outperform its benchmark.	There is no assurance that the fund will exactly match the index because of tracking error and fund expenses.

Neither approach is inherently more suitable than the other, and the choice depends on an investor’s financial goals, investment horizon, risk appetite and preferences.

Advantages of investing in active funds

Investing in active funds has many advantages that make them an enticing option for many investors. Some of them are mentioned below:

Active risk management: With experienced fund managers at the helm, active funds possess the ability to adapt swiftly to market conditions. They conduct research and analysis to identify undervalued opportunities and actively adjust the portfolios, aiming to outperform passive funds and generate relatively better returns.

Flexibility and agility: Active funds possess the freedom to explore a broad spectrum of investment opportunities, giving them the flexibility to buy securities with potential. This dynamic approach allows active funds to navigate the ever-changing market landscape and seize potential growth prospects.

Potential for alpha: Alpha refers to the excess return earned by a fund above the return of its benchmark. Active funds strive to generate alpha with the help of market insights, and strategic decision-making.

Tax management: An active fund advisor can alter tax management strategies to suit individual investors. They can advise to sell investments that are losing money to offset the taxes on the profit earning investments.

Limitations of active funds

Some of the limitations of active funds include:

• No assurance of outperforming the benchmark: An active fund may underperform its benchmark index or comparable schemes over certain periods. Active management does not guarantee higher returns.
• Higher expense ratio: Active funds generally have a higher expense ratio than passive funds because of research, portfolio management and trading costs. These expenses may affect the fund’s net returns over time.
• Dependence on investment decisions: The fund’s performance is influenced by the fund manager’s security selection, asset allocation and portfolio management decisions, which may not always deliver the intended outcomes.
• Portfolio changes over time: Active funds may buy and sell securities based on changing market conditions or investment views. These changes may alter the portfolio composition during the investment period.
• Market-related risks remain: Active management cannot eliminate market risk. The value of the fund’s investments may fluctuate due to changes in equity or debt markets, economic conditions and other factors.

Who should invest in active mutual funds?

Active mutual funds may be suitable for investors who:

• Want a fund manager to select investments rather than follow a market index.
• Prefer a portfolio that can be adjusted when company prospects, valuations or market conditions change.
• Are comfortable paying relatively higher fund management costs than those charged by passive funds.
• Want access to investment styles or strategies that may not be available through a simple index fund.
• Understand that benchmark outperformance is not guaranteed.
• Have the risk appetite and investment horizon suited to the chosen fund category. For example, an active equity fund may require a long investment horizon and a very high risk appetite.

Factors to consider while investing in active funds

While active funds offer enticing prospects, it is crucial to consider certain factors before embarking on this investment path:

Fund manager’s expertise: Assessing the track record, experience, and investment approach of the fund manager is vital. A skilled and knowledgeable manager with a proven ability to consistently deliver strong performance can enhance the prospects of the fund.

Fund philosophy and strategy: Understanding the investment philosophy and strategy of the fund is essential. Evaluate if it aligns with your investment goals, risk tolerance, and time horizon. A clear and transparent strategy can provide confidence and clarity to investors.

Fees and expenses: Consider the expense ratio and fee structure of the fund to ensure it is reasonable and commensurate with the value provided by the active management.

To conclude, active funds offer a great avenue for investors seeking dynamic opportunities and the potential for relatively better returns. By actively managing portfolios, employing expertise, and capitalising on market opportunities, these funds strive to make higher returns for the investor. However, it is essential for investors to conduct thorough research, evaluate the fund manager’s expertise, and align investment strategies with personal goals and risk tolerance for the optimum results.

FAQs:

What is the difference between active and passive fund performance?

Active funds aim to outperform a benchmark through investment decisions made by a fund manager, while passive funds seek to closely replicate the performance of a specified index.

How to know if a mutual fund is active or passive?

You can identify whether a mutual fund is active or passive by checking its scheme name and investment objective in the Scheme Information Document (SID) or Key Information Memorandum (KIM). Generally, index funds and Exchange Traded Funds (ETFs) are passive, while regular equity, debt and hybrid mutual fund categories are actively managed.

How to buy actively managed mutual funds?

You can buy actively managed mutual funds through the AMC’s website, a registered mutual fund distributor, or an authorised investment platform. Complete the KYC process, compare schemes based on their investment objective, risk, and costs, and invest through SIP or lump sum according to your financial goals.

What is the average fee for an active mutual fund?

There is no fixed average fee for actively managed mutual funds. Costs vary across schemes and are reflected in the expense ratio, which is subject to SEBI’s regulatory limits.