Last year witnessed regulatory changes in the mutual fund world with re-categorisation and rationalisation of funds. The Securities and Exchange Board of India (Sebi) has mandated large-cap schemes to invest at least 80% of the corpus in the top 100 companies.
This has limited the large-cap funds’ ability to beat the benchmark. This space has become the clash of the titans and none wins consistently! The large-cap segment is becoming more efficient than ever with well-researched top 100 stocks for all the asset managers.
Further, large-cap funds have a higher expense ratio than that of index funds and ETFs. On average, the total expense ratio (TER) of equity funds is 1.5-2%, wWhile for index funds and ETFs, it is much lower than 0.5%. Consequently, the large-cap funds may find it further difficult to outperform the benchmark index.
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Taking the account
Let us evaluate the performance of the large-cap equity funds at the end of February 2019. Note that three-year and five-year returns enjoy the favourable base effect of lower market levels prevailing at the beginning of these periods. I have considered about 30 large-cap schemes with meaningful assets under management (AUM) of at least Rs 10 crore.
Among them, 10 large-cap funds have outperformed Nifty 100 TRI over the trailing five-year period while three large-cap funds have outperformed in the three-year period. When we see the trailing one-year performance, we spot only one fund outperforming Nifty 100 TRI. In fact, there are as many as 22 funds delivering a negative return over the past one year. During the same period, Nifty, Sensex and Nifty 100 TRI delivered positive returns.
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The Nifty 100 TRI return over one-, three- and five-year periods is 2.5%, 17.29%, and 13.76% respectively. The average large-cap fund return for one, three and five-year periods is -1.22%, 14.2%, and 12.75%, respectively. What is more worrisome is the gap between the best and the worst performers. The return-range for trailing one, three and five-year is 12.10%, 13.60%, and 18.10%, respectively. Also, the only winner fund over the past one-year period underperformed the Nifty 100 TRI over a three-year period. So, consistency of the performance is yet another concern.
This explains that it is becoming increasingly difficult for the large-cap funds to beat the benchmark. At the same time, the fact is most funds struggle to match the large-cap indices performance. These funds are charging about 2% fees on average. This fee is justified if they beat the benchmark in most years. But they are not found to be as ‘smart’ as expected.
Large-cap funds
Now as the large-cap funds have failed to generate alpha, it makes sense to move towards low-cost alternatives and earn market returns. Index funds and ETFs provide such an option. When I include the index funds and ETFs in the comparison, the top ranked fund is ETF or index fund in all the trailing periods of one, three, five and 10 years. The list of top rankers by return is full of these passive, low-cost funds.
Index funds for the uninitiated
Index funds are mutual fund schemes that track the market index and follow the changes in the index closely. This is passive investing. They have lower expenses compared to active funds. Exchange Traded Funds (ETF) manage money just like mutual funds with mostly passive investing. The units are listed and traded on stock exchanges during trading hours. Their market price is impacted by liquidity also. Being passive investment and exchange-traded, their expenses are lower than that of mutual funds.
With changes in the index, the portfolio is rebalanced regularly. There is no security selection and thus fund manager bias. The attempt is to match the index performance at a low cost. You should start searching for the low-cost ETFs and index funds with minimum tracking error to invest in the market segment of your choice.
(By Nehal Joshipura. The writer is faculty member at DSIMS, Mumbai)