Time to move your large-cap portfolio to passive funds

But things didn’t quite turn out that way; the average one-year return from large-cap funds was just about 7.5 percent. Of the 29 large-cap schemes, only three outperformed their respective benchmark indices, according to data from CRISIL Ltd. Mid- and small-cap funds did much better though.

Fourteen of the 24 mid-cap funds outperformed their respective benchmark indices over the past one-year period and just two of 14 small-cap funds underperformed.

Now, if you pay around 2 percent as expense ratio to your equity fund−and we’re talking specifically of large-cap funds here−you would expect your equity funds to outperform if the markets rally.

That’s the dilemma that many large-cap fund investors are facing these days. If you think this is a short-term phenomenon, think again. Over the past five years, only 50 percent of large-cap funds have beaten their benchmark indices. The performance of funds in this space leaves a lot to be desired, leaving investors in the lurch.

Small wonder then that many investors have been warming up to passively-managed funds. These are schemes that invest in all the stocks−and in the same proportion−that lie in their benchmark indices.

The assets under management of index funds stood at Rs 5,313 crore as of April 30, 2019, which is a 73 percent jump over the value as of end-December, 2017.

Has the time come to dump actively-managed funds and switch to passive options−index and exchange-traded funds (ETFs)?

Equity funds come in different hues. Large-cap funds invest in the top 100 companies ranked according to their market capitalisation. Then, the mid-cap schemes invest in companies ranked from 101 to 250, while small-cap funds invest in those ranked 251 and below, all in terms of market capitalisation.

In late-2017, the capital market regulator Securities and Exchange Board of India (SEBI), mandated the segregation of MF schemes under 36 categories across equity, debt, and gold. SEBI tightened all the existing norms and also formalised new ones and said that all fund houses should have just one scheme per category. The objective was two-fold: to shorten the list of MF schemes in the market, and firm up and standardise the boundaries within which each scheme should operate.

While most schemes benefited from this new rule, large-cap funds found the rules restrictive. Not that the rules were bad; in fact, standardisation was a good move as different large-cap schemes used to have different definitions of their mandate earlier.

Some large-cap schemes used to pick stocks within the 100 largest stocks ranked by market capitalisation, while many others used to expand their horizon to top 200 and still call themselves large-cap funds.

But now, with the universe of large-cap stocks having formally shrunk to just 100 (by SEBI’s definition), the space for large-cap funds has shrunk.

To be sure, SEBI has mandated that at least 80 percent of a large-cap fund must be invested in large-cap stocks; the rest can be parked elsewhere, including picks from the mid- and small-cap stocks space for instance. This 20 percent leeway provided to these large-cap funds, some investment advisors argue, is their last chance at redemption.

The rest of the investment universe is common for all large-cap funds.

But that is not the only challenge for large-cap funds. A deep dive into the large-cap indices tells us that only a few stocks have been driving up the index. So far this year, the S&P BSE Sensex TRI (Total Return Index) has gone up by almost 10 percent. But just three of the 30 stocks in the index contributed 53 of the gains−Reliance Industries, TCS and HDFC Bank.

This pattern has existed for a while. Between 23 March 2018 and 23 July 2018, the Nifty 50 TRI went up by 10.87 percent. But just seven of the 50 stocks contributed to 81 percent of the index’s gain, according to Bloomberg data.

A typical actively-managed large-cap fund would have around 50 stocks in its portfolio. Not only is it impossible to correctly identify such a narrow band of stocks that’ll do well in future, but it’s also impractical for any fund to hold just a handful of such stocks, even assuming the manager has correctly identified them.

The performance of indices wasn’t this narrowly-led before. In 2014, when the S&P BSE went up by about 30 percent, 27 of the 30 stocks had gone up with just one stock having contributed more than 10 percent to the rally.

In 2007 as well, when S&P BSE Sensex went up by 47 percent, just one stock contributed more than 10 percent to the rally.

Although active fund managers claim that they would be able to generate returns in excess of benchmark indices, many insist on increasing the holding period of such funds to be able to see outperformance. So, you will need to stay invested for a lot longer for better returns.

Meanwhile, fund houses and many distributors and investment advisors have sensed the winds of change and have started talking about passive funds. But fund houses are also looking at smart-beta and quant funds that are variants of plain-vanilla passive funds. A smart-beta fund is a passive scheme based on a stock market index that is constructed using pre-defined parameters to filter out stocks. Here, the index is maintained by an external index provider and is open to all fund houses.

A quant fund is a slight variant. Here, the fund picks stocks based on a filter that gives out a basket of companies to invest in.

But these are new products and yet to be tested across market cycles.

There is no denying that life has just got tougher for active funds. While mid-, small- and even multi-cap funds (those that invest in stocks across market capitalisation) will continue to outperform, large-cap funds will find the going difficult. The fact that there is information symmetry in this basket of stocks given that most analysts and fund managers track these companies, doesn’t help.

Some financial advisors have already started recommending passive funds for a large-cap allocation and active funds for mid- and small- cap allocation in investors’ portfolios.

Here’s a thought: a combination of a Nifty or Sensex fund and a Nifty Next 50 index (a rock solid index not consisting of mid-cap stocks which have outperformed even mid-cap funds in the past) is a good enough alternative of a typical large-cap fund. Low expenses of these index funds help. The actively-managed mid- and small-cap funds still remain good enough to generate the kicker in returns.

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