Active and Passive Funds: How They Can Complement Your Portfolio

As a result, the common question among many investors is whether they should prefer passive funds over active funds. In this article, we will discuss how both these kind of funds can co-exist and complement your investment portfolio.

What are Active Mutual Funds?

An active mutual fund is one in which the fund manager, supported by a research team, actively decides:

• Which stocks to buy or sell

• The quantity of each holding

• The timing of these decisions

The objective of an active fund is to outperform a benchmark index by identifying opportunities that may not be fully reflected in market prices. This approach is based on the belief that markets are not always perfectly efficient and that informed decision-making can add value over time.

What are Passive Mutual Funds?

A passive mutual fund aims to replicate the performance of a benchmark index rather than outperform it.

These funds invest in the same securities that constitute the index, in the same proportion. Portfolio changes occur only when the index itself is rebalanced. The role of the fund manager is limited to ensuring minimal tracking error.

The objective of passive funds is cost efficiency and consistency, offering investors market-linked returns at a lower expense.

Active vs Passive Mutual Funds: Key Differences

These differences provide a framework, but the decision between active and passive investing requires deeper context.

Active and Passive Approaches in Large-Cap Funds

Large-cap funds deserve special consideration when comparing active and passive approaches.

Over time, the large-cap segment has become increasingly efficient. Regulatory definitions have narrowed the large-cap universe to the largest companies by market capitalisation, reducing the range of stocks available for active selection. These companies are widely researched, heavily tracked, and actively traded, resulting in high information availability.

In such an environment, return differences between actively managed large-cap funds and their benchmark indices tend to be relatively narrow over longer periods. As a result, cost efficiency becomes an important factor when evaluating large-cap exposure.

Passive index funds, which aim to replicate benchmark performance at lower costs, are often considered suitable for this segment. This does not imply that active management is ineffective, but rather that the scope for differentiation varies across market segments.

Understanding “Index Hugging” in Active Funds

An important concept investors should be aware of is index hugging.

To avoid significant underperformance, some active fund managers construct portfolios that closely resemble their benchmark index. While this reduces the risk of falling meaningfully behind the index, it also limits the potential to outperform it.

In such cases, investors may:

• Pay higher expense ratios associated with active funds

• Receive returns that closely mirror the benchmark

This highlights the importance of evaluating how actively a fund is managed, not just whether it is classified as active or passive.

Where Active Management Can Play a Meaningful Role

Market efficiency is not uniform across all segments.

In categories such as:

• Mid-cap funds

• Small-cap funds

• Flexi-cap funds

• Thematic or value-oriented strategies

companies are often less researched, business models may be evolving, and growth potential may not be fully recognised. In these segments, fund managers typically have greater flexibility and scope to make differentiated investment decisions.

For long-term goals that are many years away, selective exposure to actively managed funds in such categories may help improve portfolio outcomes, provided risks are understood and managed appropriately.

Factors to Consider Before Choosing Active or Passive Funds

When deciding between active and passive mutual funds, investors should consider:

• Expense ratios and costs

• Market efficiency within a category

• Investment time horizon

• Risk tolerance

• The role of the fund within the overall portfolio

Rather than treating active and passive investing as opposing strategies, it is often more effective to recognise that different market segments reward different approaches.

How Active and Passive Funds Can Complement Each Other

Active and passive funds need not compete within a portfolio.

A commonly followed approach involves:

• Passive funds for large-cap exposure, where cost efficiency and market efficiency dominate

• Active funds for mid-cap, small-cap, or flexible strategies, where fund managers may have greater scope to add value

Such a combination allows investors to balance cost control with selective active risk, aligning portfolios more closely with real-world market behaviour.

Active and Passive Funds Can Co-exist in Your Portfolio

The decision between active and passive mutual funds is not about choosing a side. It is about understanding where each approach fits best, based on market characteristics, costs, and long-term goals.

When used together thoughtfully, active and passive funds can play complementary roles in a portfolio, helping investors participate efficiently across different segments of the market while remaining aligned with their financial objectives.

FAQs

Why do active funds usually have higher expense ratios?

Active funds incur higher costs due to research, portfolio management, and trading activity. These costs are borne in expectation of potential outperformance.

What types of passive funds are available?

Passive funds include index funds and exchange-traded funds (ETFs), both designed to track benchmark indices.

What is a benchmark index?

A benchmark index represents a segment of the market that a fund seeks to track or outperform, such as the Nifty 50 or Nifty Midcap 150.