A fund manager in a large-cap fund must invest a minimum of 80% of the portfolio in the top 100 companies by market capitalization, as per the norms that have been laid down by SEBI. The rest of the portfolio is free to be invested in mid-cap stocks, small-cap stocks, and debt instruments.
Based on annualized daily rolling returns, a lot of large-cap funds have failed at beating their indices and passive funds. Even when looking at this data from the long term perspective of two decades, 57% large-cap funds have underperformed both in the NIFTY 50 index and in the BSE Sensex.
Unlike large-cap funds that are actively managed, passive and large index funds mirror the same composition as that of large-cap indices, such as NIFTY 100, NIFTY 50, S&P BSE Sensex, and so on. When it comes to the fund manager of these schemes, they do not have an option to choose stocks. They need to mimic the allocation of these indices by keeping the tracking error ratio close to zero.
A 5-year CAGR return outperformance of large-cap funds against the respective indices and passive funds was also calculated, Graphs of the same show how the outperformance of large-cap funds have fallen to an extent that it has now reached the negative zone of its underperformance. This then naturally brings concern to the sustainability of the large-cap category and the managers.
The equity market has become very competitive over the years, has matured tremendously. This is making it difficult for fund managers to beat the indices. Further, the introduction of the Total Return Index, which includes all dividends that have been declared by the companies, shows the true picture. It has also helped to narrow down the gap between funds and indices. Fund managers are now under immense pressure to generate returns for investors.
The following are some major reasons that have led to the underperformance of the large-cap category.
The manager has very limited space within the large-cap segment. Only 20% is available outside to take certain calls to beat indices. And of this 20%, only 7.6% of the allocation is deployed to mid and small-cap segments. Sadly, this is not enough to generate enough alpha for outperformance.
To outperform indices, the manager needs to choose the right stocks, and then also give them the correct weightage in the portfolio. Considering the underperformance of most funds in the category, even this is not going well.
High expense ratios
The reason why an investor pays such high fees to the manager is because of today’s alpha generation. But there is no point in paying such high fees when the funds cannot beat the index. The average expense ratio of large funds is 2.24, as compared to the 0.67 of NIFTY 50 and Sensex Funds. This has further pulled down the returns of large-cap funds and has drained the investors’ pockets.
What can investors do?
The outperformance of large-cap funds might reduce further as the Indian markets will develop and become more and more self-sustainable. Though there exist large-cap funds that have outperformed, the sustainability of their outperformance is not guaranteed either. And though we might see some funds that will surely outperform in the future, at this point it is difficult to bet on the right ones.
In conclusion, it makes a lot more sense for investors to invest in passive large-cap funds. But the question here is which funds? The very beauty of investing in Sensex and NIFTY 50 lies in the very framework and the composition of the index itself. As per respective market capitalization, these indices themselves scale up performing stocks and kick out the ones that are not performing. Investors also have the option to choose a concentrated portfolio of the top 30 stocks from the SENSEX and the less concentrated ones from the top 50 listed in NIFTY 50. The indexing framework also gives investors the benefit of automation and the simplicity of investing.