Let's say you have a pool of money or savings that you keep for a specific purpose, which is a fund when it comes to investing terminology. Now, there are two ways by which you can invest your funds: one is active, and the other is passive, depending on the kind of funds you have. 

Passive funds mainly involve index funds and ETFs, which aim to trace the performance of a specific market index and offer a low-cost and hands-off approach for investors like you. Conversely, active funds involve a hands-on approach by some skilled fund managers, basically traders, who make dynamic investment decisions to speculate the market. 

While passive funds generally have lower fees and track market benchmarks, active funds rely more on functional management expertise that eventually aims to lead to higher returns or increased risks. Investors like us choose between these options based on their financial goals, risk tolerance, and preferences for management styles, recognizing the distinct characteristics each strategy offers in investment management.

What are Active Funds?

As we know, actively managed funds are investment funds overseen by financial experts who actively choose which assets to acquire, sell, and modify within the fund's portfolio. These fund managers adjust their strategic investment selections based on market conditions and use research, analysis, and experience. Active funds strive to produce returns higher than the market average, in contrast to passive funds, which copy the performance of an index. However, because active management and research are required to attain excellent investment performance, active funds usually have higher management fees.

What are Passive Funds?

Passive funds, such as index funds and exchange-traded funds (ETFs), are investment vehicles designed to replicate the performance of a specific market index or benchmark. These funds aim to mirror the overall market rather than relying on active management decisions. Passive fund managers follow a predetermined set of rules to maintain a portfolio resembling the index they track. This strategy generally results in lower management fees and reduced portfolio turnover compared to active funds. Passive funds offer investors a cost-effective and low-maintenance way to gain broad market exposure, making them an attractive option for those seeking diversified, long-term investments. Eventually, Passive Investing in India has seen remarkable growth.

Key Differences Between the Two

1. Investment and Management Style

A hands-on approach, active investing involves the fund manager being wholly engaged in the investment process. The professional does it all: study the market, hunts for opportunities, and buys and sells stocks. In contrast, passive investing involves investing in securities in the same proportion as the index, with the fund management having very little control over stock selection and market timing. The scheme's goal is to duplicate the benchmark results.

2. Costing

Passive Funds' low turnover, rule-based approach results in generally cheaper management fees. In contrast, fees for Active Funds are often more significant because they cover the costs of active management and research.

3. Risk Management

By using rule-based investing based on the weight of companies in the benchmark, passive mutual funds reduce unsystematic risks such as stock selection and portfolio manager choice. Active funds may carry a higher risk depending on the type of fund. Compared to an active debt fund, an active equity fund may entail a higher risk.

4. Expense Ratio

Given that their fee ratios are often lower than those of active mutual funds and can reach a maximum of 1%, passive mutual fund schemes give investors an affordable choice. This is mainly because, unlike active funds, passive mutual fund schemes do not necessitate the active purchasing and selling of stocks. They make an effort to mimic the standard. 

5. Profit returns

By adhering to a benchmark, passive index funds produce returns comparable to the aggregate returns of the stocks included in the benchmark's past expense ratio and tracking error. Actively managed funds, however, may need to be more consistent. They take advantage of the fund manager's expertise and experience to provide profitable returns. Their main goal is to outperform the benchmark, and they might provide more significant returns.

Which is better to invest in, Passive or Active?

Let’s cater to this question based on the pros and cons of both forms of funds-

Passive Funds

Pros

• They have far lower expense ratios than actively managed funds. The SEBI regulations state that an ETF's fee ratio cannot exceed 1%. 
• A more comprehensive picture of the Indian stock market is provided by Passive Funds indices such as the Total Market Index, which has a portfolio of around 750 stocks. Thus, you can access a variety of equities with a single investment if you're investing in a fund that tracks the Nifty Total Market Index.

Cons

• The returns on these funds are moderate. 
• Returns could match or fall short of the benchmark's returns. 
• They might be less expensive, they come with a few fees that could slightly reduce the profit.

Active Funds

Pros

• Actively managed funds are preferable if the investor desires something more than what the benchmarks are providing. 
• Creating "alpha" and outpacing the returns of the Sensex and Nifty are the primary goals of actively managed funds. 
• The fund manager does market research using their skills, knowledge, and time.

Cons

• Naturally, there is a cost to everything excellent in life, and fund managers' knowledge is no exception. Expense ratios are the costs that investors must pay for the fund manager's judgment and experience. 
• Compared to passive funds, actively managed funds have a higher risk profile because they aim to provide larger returns. This is due to the possibility of inaccuracy in the decision-making processes of humans like us.

Now we can say that determining whether active or passive investment strategies are 'good' or 'bad' isn't straightforward. It's more about understanding the distinct features of each strategy rather than assigning a value judgment. The suitability depends on the investor's profile. An ETF's direct mapping to an index characterizes passive funds. If an investor seeks active management, has the financial capacity for an active fund, and aligns with the associated risks and goals, active funds might be a viable choice. On the other hand, if an investor prefers minimal manager intervention, wants the fund to closely follow the benchmark, and seeks a lower-risk approach, passive funds could be a suitable option.

Conclusion

In conclusion, the decision between active and passive investment strategies hinges on recognizing their key differences. Active funds, led by skilled managers, aim to outperform the market but come with higher fees and increased risk. On the other hand, passive funds, like index funds and ETFs, mirror market indices, offering lower fees and reduced risk. Active funds might be preferred for those seeking hands-on management, potentially higher returns, and willing to bear added costs and risks.