As most large-cap equity funds have underperformed their benchmarks, with 88% of actively managed funds underperforming the S&P BSE 100 last year according to S&P Indices Versus Active Funds India Scorecard for 2022, investors should gradually move to passive large-cap index funds for higher returns. When markets go through a lean phase and the fear factor is high, investors rush to redeem. As a result, fund managers have to keep cash ready so that they do not have to redeem their purchases. This leads to underperformance when the markets rise.

Moreover, the investment universe of large-cap funds is limited to only 100 companies —NIFTY 50 accounts for more than 80% of the total market cap of top 100 stocks —which leaves less room to generate alpha. So, to be able to stay with the benchmark index, most active funds have no choice but to be heavy on NIFTY stocks.

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Harish Menon, co-founder and head of Investments and product research, House of Alpha, says there is very little room to pick stocks actively within the limited universe of top 50-60 stocks. “Even if a fund manager is able to deliver some alpha within these limited numbers of stocks, the expense ratio eats it up. The average under-performance of most active large-cap funds vis-a-vis index is just the expense ratio of the fund which is typically 1.2-2% per annum,” he says.

Diversify risks

When the markets are volatile, passive funds always perform well. Investing in passive large-cap funds can work well in such circumstances and the impact of the market volatility will be minimal.

Anil Rego, founder, Right Horizons PMS, says active mutual funds typically have higher fees than index funds and the index fund performance is relatively predictable. “Investors should always focus on diversifying the funds between active and passive large-cap funds to overcome the negative impact when the market is volatile,” he says.

Active funds perform as per the discretion of the fund manager, who could go wrong with their choices. While investing in large-cap funds, Nitin Rao, head, Products and Proposition, Epsilon Money Mart, says investors should look at their risk appetite before taking the plunge. “Churning the portfolio every year, other than being suboptimal when investing for a particular goal, attracts loads of unwanted taxes as well. A mixture of different investment styles, allocation in various asset classes as well as sharper focus on cost versus returns for efficient alpha generation should be kept in mind,” he says.

Gradually exit active large-cap funds

Experts say investors who want large-cap allocation in their portfolio must stick to index funds now. They can choose from Nifty, Sensex or NIFTY Next 50 funds. Index funds are available at a very low expense ratio and that itself translates into alpha. “I would consider an actively managed large- cap fund only if they are able to use their hedging option (through NIFTY Futures/Options) very effectively to reduce the drawdown during market corrections,” says Menon.

Avoid comparing with small-cap and mid-cap

Some investors may be tempted to invest in small-cap and mid-cap funds because of the underperformance of large-cap funds. However, it is not prudent to compare mid and small-cap funds with large cap funds. If the former categories are able to generate higher returns, it also comes with larger volatility and drawdown.

The volatility in small- and mid-cap funds will be more when compared to large-cap and when the market is underperforming, the impact on large-cap funds will be less when compared to mid- and small-cap funds. “I would not advise investors to choose small-/mid-cap funds over larger-cap just to chase higher returns. One needs to assess risk profile and suitability for high risk funds,” says Menon.

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CHASING ALPHA

* Investment universe of large-cap funds is limited to only 100 companies which leaves less room to generate high returns

* Large-cap index funds are available at a very low expense ratio and that itself translates into alpha

*Average under-performance of active large cap funds vis-a-vis index is just the expense ratio