Investment word of the day: Active funds – How they work and can help you beat markets

Investment word of the day: Investing in the stock market may be intimidating, especially for beginners. Many struggle with understanding essential stock market terms, making the process complex. 

Here's a simple guide to one such term: active funds. Let's see what active funds are, how they work, and why they matter.

What are active funds?

Investors can choose between two types of prominent mutual funds: active and passive. Active funds or actively managed mutual funds require a professional fund manager who chooses and manages a portfolio of securities in accordance with market indices such as S&P 500, Nifty 50, etc. Unlike passive funds that simply track the performance of an index, active funds take a more hands-on approach, aiming to secure higher returns.

How do active funds work?

Fund managers, along with analysts and researchers, actively monitor market trends and economic conditions to make investment decisions. They buy, hold, or sell securities to maximise returns and outperform specific benchmark indices.

Key features of active funds

• High costs - Active funds involve higher expenses, including trading charges, management fees and research costs, resulting in higher expense ratios than passive funds.
• High risk - Active funds carry a high risk due to their extreme and direct reliance on the market, and the ability of the fund manager to handle the portfolio.
• Scope for higher returns - Active funds may provide higher returns as they directly try to outperform market trends.

Types of Active Funds

• Balanced funds: Invest in both equities and fixed-income securities, adjusting their ratios based on market conditions.
• Equity funds: This type of active fund invests in stocks, mostly aiming for long-term growth. They are often considered to be high-risk investments.
• Bond funds: Also known as fixed-income funds, investments are made in bonds and other debt instruments with the aim of a steady income.
• Index funds: These types of funds are typically managed passively. However, certain index funds can be managed actively as well. They contain securities from both a benchmark index and other securities.
• Sector funds: Active funds that focus on specific sectors, such as healthcare, technology, etc, are called sector funds. Securities are selected on the basis of growth potential in each sector.
• Fund of funds: Under this type of active fund, investments are made in a diversified portfolio consisting of a set of mutual funds instead of investing directly into bonds, stocks, or any other securities.
• International funds: As the name suggests, international funds make investments in specific securities available globally.

Active vs Passive funds

• Active funds aim to outperform specific market indices, while passive funds try to mimic them.
• Active funds are managed by fund managers who analyse market conditions and invest accordingly. In passive funds, investments are based on the performance of market indices.
• The risks associated with active funds are much higher than those of passive funds, as they rely on the fund manager's judgement. Meanwhile, passive funds track market indices, minimising the risk of individual judgement.