Active vs Passive Investing: Which Strategy Delivers Better Returns?

The direct answer: neither active nor passive investing is guaranteed to deliver higher returns. Active investing tries to outperform a benchmark through investment decisions, while passive investing generally seeks to track an index. The right choice depends on cost, strategy, tracking quality, investment horizon and your confidence in the strategy.

That distinction is important because investors often ask:

"Which one gives higher returns?"

A better question is:

"What am I paying for, and how consistently has the strategy delivered after costs?"

What is active investing?

Active investing means making investment decisions with the objective of achieving a particular outcome, often beating a benchmark.

In an actively managed mutual fund, a fund manager and investment team decide which securities to buy, hold or sell within the scheme's mandate.

For example, an active large-cap fund may hold a portfolio of large companies but its manager can change the portfolio based on valuation, earnings expectations, business quality or other investment considerations.

The objective is generally not simply to reproduce an index.

What is passive investing?

Passive investing generally attempts to replicate the performance of a predefined index.

For example, an index fund may seek to track an equity index by holding securities in a manner designed to reflect that index.

SEBI classifies passive schemes such as index funds and ETFs separately from active equity and debt scheme categories.

The passive fund does not need a manager to continuously decide which company should replace another based on an individual investment view. Its objective is primarily to follow the selected index.

Active vs passive funds: the key difference

SEBI investor material explains that tracking error measures how much a portfolio such as an index fund or ETF deviates from its benchmark.

Does active investing produce higher returns?

It can, but it does not consistently do so across all funds or periods.

An active manager may outperform the benchmark after costs. But an active manager may also underperform.

The distinction between "possible" and "reliable" matters.

S&P Dow Jones Indices' SPIVA India Year-End 2025 scorecard provides a useful independent check. It reported that Indian active large-cap funds had a 75.0% one-year underperformance rate against the relevant benchmark in 2025. Over the 10-year period ending December 2025, the underperformance rate was 76.3%. Indian ELSS funds had an 82.9% 10-year underperformance rate in the same scorecard. However, mid-/small-cap active funds had a very different short-term result, demonstrating that outcomes vary considerably by category.

The lesson is not that active funds never outperform.

The lesson is that identifying future outperformers is difficult.

Does passive investing always beat active funds?

No.

Passive funds can underperform their benchmark slightly because of expenses and implementation differences. SEBI's explanation of tracking error makes clear that a fund can deviate from the index it aims to replicate.

A passive investor also accepts the performance of the underlying index.

If the index falls, the passive fund will generally fall as well.

So passive investing is not "risk-free investing".

It is a different way of managing market exposure.

Why are passive funds generally associated with lower costs?

An active fund involves research, security selection and portfolio management. A passive fund primarily follows an index.

That can reduce some investment-management costs.

AMFI explains that the Total Expense Ratio (TER) represents the operating expenses charged to a mutual-fund scheme, and that TER is deducted through the fund's NAV.

Costs matter because investors receive returns after expenses, not before them.

For example, suppose two otherwise similar strategies both generate 12% gross return.

If one costs 0.5% and another costs 1.5%, the difference compounds over time.

This does not mean every passive fund is automatically superior. It means investors should understand what additional cost they are paying and what they expect that additional cost to provide.

What is tracking error?

Tracking error measures how much the performance of a portfolio differs from its benchmark over time. SEBI Investor explains it as a measure of the difference between a portfolio's returns and its benchmark.

For a passive fund, an investor generally wants the fund to follow its benchmark closely.

Suppose an index returns 10% over a period and the passive fund returns 9.5%.

That difference can arise from expenses, cash balances, transaction effects and portfolio implementation.

Therefore, when comparing passive funds, don't look only at the index's return.

Look at how effectively the fund tracks the index.

How should an investor compare an active fund with a passive fund?

Use five questions.

1. What is the benchmark?

You cannot evaluate active performance properly without understanding the benchmark.

An active fund that returns 14% sounds impressive.

But what if its benchmark returned 16%?

The fund generated a positive return but still failed to outperform the benchmark.

2. How consistent has the relative performance been?

One exceptional year does not prove persistent skill.

Look at multiple periods and understand market cycles.

3. What does the fund cost?

Expense ratio is important because it directly affects NAV.

4. Does the strategy fit your portfolio?

An active mid-cap fund and a Nifty 50 index fund are not substitutes merely because both are equity funds.

Their underlying exposures are different.

5. Can you stay invested when the strategy underperforms temporarily?

This question is often ignored.

An investor may buy an active fund because of its past performance and then exit when it underperforms for two years.

That behaviour can defeat the original investment thesis.

When can active funds make sense?

Active investing can make sense for investors who:

• want exposure that differs from a broad index;

• are comfortable evaluating active strategies;

• accept that a fund may underperform;

• are willing to review the fund's portfolio and process;

• understand the costs involved.

It may also be relevant in market segments where index construction or portfolio constraints create different opportunities.

But this should be established through evidence rather than assumed.

When can passive funds make sense?

Passive funds can be attractive to investors who want:

• a transparent rules-based strategy;

• broad benchmark exposure;

• relatively low-cost implementation;

• limited dependence on an individual manager;

• a simple long-term portfolio.

SEBI's mutual-fund investor material highlights transparency, diversification and regulation as important features of mutual funds.

Is an index fund automatically better for a beginner?

No.

An index fund can be simple, but simplicity does not remove investment risk.

A beginner still needs to decide:

• equity or debt?

• which index?

• what investment horizon?

• how much volatility can be tolerated?

• how much should be invested?

Choosing a passive fund is not the same as choosing the correct asset allocation.

Kuberzo's guide to different types of mutual funds can help investors understand how equity, debt, hybrid and passive categories differ.

Active vs passive: a practical example

Suppose two equity funds both have ₹5 lakh invested.

Fund A: Active fund
Expense ratio: higher
Objective: outperform a benchmark
Result: 13% annualised return before considering the investor's tax implications

Fund B: Passive index fund
Expense ratio: lower
Objective: track benchmark
Result: 12.2% annualised return

Fund A is not necessarily "better" simply because its return is higher.

The investor should ask:

• What did the benchmark return?

• How much did Fund A outperform or underperform after expenses?

• Was the difference consistent?

• What level of risk did each portfolio take?

That is the correct active-passive comparison.

One major mistake: chasing the current winner

Suppose an active fund has delivered exceptional returns for two years.

An investor sees the ranking, invests and expects similar performance.

The fund then underperforms.

The investor switches into another top-performing fund.

This creates a cycle of performance chasing.

The SPIVA evidence is relevant here because it shows how difficult persistent outperformance can be across categories.

Past outperformance can be evidence worth investigating, but it is not proof of future outperformance.

Does passive investing eliminate the need to review investments?

No.

Even a passive portfolio needs periodic review.

The investor should check whether:

• the selected index remains appropriate;

• the asset allocation remains suitable;

• the fund's tracking performance remains reasonable;

• the investment horizon has changed;

• the investor's financial goals have changed.

Kuberzo's Active Portfolio Tool can help investors understand hypothetical portfolio shifts and their mathematical impact. Its outputs are scenario estimates rather than predictions or guarantees.

So, active vs passive investing: which should you choose?

There is no universally correct answer.

Choose active only because there is a rational reason to believe the specific strategy justifies its cost and risk—not simply because the fund had a high recent return.

Choose passive when you value broad benchmark exposure, rules-based investing and cost efficiency, while accepting that you will participate in the benchmark's downside as well.

The strongest decision is often not "active or passive?"

It is:

"Which strategy can I understand, afford, stick with and evaluate objectively?"

Financial disclaimer

This article is educational and does not constitute personalised investment advice. Mutual funds are subject to market risks. Past performance, including benchmark outperformance, does not guarantee future results.