Differences Between Active and Passive Portfolio Management
- 6 min read
Achieving your financial objectives requires selecting the appropriate portfolio management strategy. While some investors actively adjust their portfolios to increase returns, others favour a low-maintenance strategy that monitors the market.
For investors who want to maximise their strategy and portfolio management, choosing between active and passive portfolio management is crucial. Read this blog to understand the differences between active and passive portfolio management, which can be appropriate for you.
What is Active Portfolio Management?
Active portfolio management involves a professionally managed collection of securities, where fund managers aim to outperform benchmark indices like the Nifty 50 or BSE Sensex. To achieve this, they apply strategies such as stock picking, sector rotation, market timing, and risk management, all tailored to maximise returns beyond what the benchmark delivers.
Investors opting for this approach must pay service and operational fees, which are included in the fund’s expense ratio. These charges vary based on the fund’s asset class and strategy and can reduce overall returns. Despite the potential for higher gains, the cost factor is an important consideration for investors.
In the case of equity funds, expert fund managers actively decide which stocks to include or remove based on the performance of individual companies, market conditions, and economic trends. They also evaluate whether to increase, reduce, or maintain the concentration of specific stocks within the portfolio.
What is Passive Portfolio Management?
Passive portfolio management is an investment approach where the portfolio is designed to mirror the performance of a benchmark index. Instead of making frequent trading decisions, fund managers follow predefined rules or formulas to match the index’s weightage. They only rebalance the portfolio when there are changes in the index composition.
Unlike active portfolio management, passive strategies involve minimal buying and selling, resulting in lower management fees for investors. As a result, the expense ratio of passively managed funds is significantly lower, making them a cost-effective option. These fees are usually built into the portfolio itself.
A common example of passive management is Exchange-Traded Funds (ETFs). These funds are structured to replicate the performance of an index. Rather than fund managers selecting individual stocks, the Securities and Exchange Board of India (SEBI) decides what is included or removed from the index, and the ETF simply follows suit, generating returns that reflect the index’s movements.
Difference Between Passive and Active Portfolio Management
Investors in passive portfolio management aim to replicate the performance of the market by tracking an index rather than outperforming it. Conversely, investors in active portfolio management hope to outperform the market by carefully selecting stocks and other investments. The table below highlights other differences between active and passive portfolio strategy:
| Parameters | Active portfolio management | Passive portfolio management |
| Definition | A portfolio created with a specific strategy by experts | Portfolio created to reflect the performance of indices. |
| Objectives | Aims to outperform the market index | Aims to replicate or match the market index |
| Expense Ratio | Depending on debt or equity composition, the ratio ranges from 0.5% to 2.5% | The ratio does not surpass 1.25% |
| Strategy | Fund managers actively adjust portfolios according to their judgment | Fund managers replicate the movement of the benchmarks |
| Risk Levels | Increased risk due to active decisions and market timing | Market-level risk |
| Tax Efficiency | Higher turnover can result in higher capital gains distribution | Lower capital gains compared to active portfolio management |
| Cost | Higher costs due to trading and analysis | Lower expenses since the managers do not actively select securities |
Advantages of Active Portfolio Management
As you are aware of the differences between active and passive investment management, you must know the advantages of using both approaches. Here are the advantages of active portfolio management:
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Utilisation of Risk Profile
Fund managers may fully utilise investors’ risk profiles when they actively manage their assets.
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Higher Returns
By identifying high-potential assets and adjusting portfolios appropriately, active managers outperform the market and gain higher returns.
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Risk Management
Active portfolio managers can also take a defensive approach in market downturns. This helps to protect capital from losses.
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Diverse Strategies
Active portfolio managers utilise different techniques like fundamental and technical analysis, stock picking, and sector rotation to generate returns.
Advantages of Passive Portfolio Management
The main goal of passive investment management is to provide returns that are comparable to those of a benchmark index. Below are some of the advantages of passive portfolio management:
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Long-term Focus
Since passive strategies are predicated on the idea that markets typically rise over time, they perform best over a long-term horizon.
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Tax Efficiency
Passive investing is more tax-efficient as fewer trades result in less taxable capital gains.
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Lower Costs
Since a passively managed portfolio does not involve continuous buying and selling of securities, costs are lower compared to active portfolio management.
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Convenience
It is simple to monitor performance because understanding the performance of the underlying index will provide the necessary information.
Final Thoughts
Understanding the differences between active and passive portfolio management helps you choose between these two strategies. If you want a low-cost strategy and prefer market-matching returns, then choose passive management. However, if you want to take risks for higher returns and tolerate volatility, then go for an active management strategy.
Do you want to create an investment portfolio? Download the PL Capital Group – Prabhudas Lilladher application and open a Demat account for free! PL Capital also offers portfolio management services to you with the help of experienced managers.
Frequently Asked Questions
1. Which approach is more economical: passive or active management?
Since the fund managers do not actively select securities, passive portfolio management is more economical than active portfolio management.
2. How to compare the returns between active and passive portfolio management?
Comparing the returns between active and passive portfolio management depends on the understanding of different factors. Active management aims for higher returns but comes with higher fees. On the other hand, passive management reflects the market returns but has comparatively lower fees.
3. What role do fund managers play in active and passive portfolio management?
In active portfolio management, fund managers actively adjust the portfolio according to their judgment. In passive portfolio management, fund managers replicate the movement of the benchmarks.
4. How to manage the risks in active and passive portfolio strategies?
While active risk management regularly modifies risk management plans in response to market conditions, passive risk management manages market risks under a predetermined strategy.
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Disclaimer: This blog has been written exclusively for educational purposes. The securities mentioned are only examples and not recommendations. It is based on several secondary sources on the internet and is subject to changes. Please consult an expert before making related decisions.
