Mutual Funds: Should you choose index funds over large cap funds for better returns?

Updated: August 22, 2019 4:57:28 PM

The performance of index funds in the calendar year 2018 may suggest that they are better than large cap funds. However, is that really the case?

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Over the last year-and-a-half, you would have come across a lot of articles and blogposts on Index Funds and how they have outperformed Large Cap Funds. However, this was largely a phenomenon of the calendar year 2018 when the Nifty50 Index Funds delivered close to 4% returns while many Large Cap mutual funds gave lower or negative returns. So, if you are not sure which one you should be investing in, read on to find out more!

What are Index Funds?

As an investor, if you want to create wealth over the medium term (3-5 years) with medium volatility, most advisors would recommend you to invest in a large cap equity mutual fund, which in turn invests majorly in large companies. Now, you have 2 investment options in mutual funds:

1. Actively managed funds — Here the fund manager decides which companies/sectors to invest in and which not to invest in, based on his/her understanding of the market and the expected performance of the companies/sectors. Most large/mid/small cap mutual funds, which we regularly hear about, are actively managed mutual funds. Since we are concentrating on investment in large companies, we will focus on large cap mutual funds.

2. Passively managed funds — These simply imitate the composition of an index which can be any of Nifty50, Nifty Midcap100, BSE Smallcap, etc. Index funds are an example of passively managed mutual funds. For example, an Index fund tracking Nifty50 will invest in all the 50 companies just like the index itself. Since we are concentrating on investment in large companies, we will focus on Nifty50 Index funds for comparison with large cap mutual funds. NIFTY 50 is the index of 50 largest companies based on free float market capitalization methodology i.e. based on the value of shares of the company in active circulation.

Key Differences – Active vs. Passive

The fund manager of an actively managed Large-cap fund decides which stock or sector to invest in, i.e. he takes decisions actively. Basically, active fund managers are working harder to potentially make you more money on your investment and are going to charge you more, hence a relatively higher expense ratio. On the other hand, the Index Fund manager has to imitate the composition of stocks in the underlying index and hence would be charging you a relatively lower expense ratio.

Hence in terms of performance, if the fund manager’s views are right, he can generate higher returns (out performance) compared to the benchmark (Nifty50 in this case). However, if his views don’t turn out to be right, it can lead to lower returns (under performance).

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Is it time to go passive?

The performance of index funds in the calendar year 2018 may suggest that index funds are better than large cap funds. But like most decisions with respect to investments, what matters is long term performance and not short term out-performance.

So let us look at the average returns generated by large cap funds compared to index funds for the last 10 years from 2009 to 2018.

Over the last 10 years, Largecap funds have outperformed Index funds in 9 of 10 years. It is only in 2018 that Index funds performed better than Large Cap funds. This was majorly due to the skewed nature of performance of very few large stocks constituting Nifty50. These few large stocks in Nifty50 performed well while most stocks remained flat or declined. Hence although the Index moved higher, any diversified mix of stocks suffered due to most stocks not doing well, leading to large cap funds failing to match the performance of index funds.

This skewed nature of market behavior may not be sustainable and hence large cap funds have the potential to outperform the benchmark/Index. However, some people argue that as Indian markets and the economy become more developed, it would be increasingly difficult for active fund managers to generate returns higher than benchmarks. And Index funds may beat Large Cap funds due to lower expense ratios.

The trend of shifting from actively managed funds to passively managed funds has become popular in the US over the last few years. However, comparing a developing economy like India with the developed economy like the US would not be correct. In a developing economy like India, where there is limited mutual fund penetration, excess returns (over index funds) may still be generated through active stock/sector decisions by the Fund Manager / AMC.

In this context, for most investors who are looking to create wealth over medium-to-long term with medium volatility, large cap funds may continue to be a better investment option compared to index funds. However, a new investor looking for equity exposure can start with index funds to get a flavor of the equity markets, as he is most likely to understand index returns given it is widely reported in business news. Even for an experienced investor looking for index-like returns at low cost, index funds can be chosen with the knowledge that scope for out-performance is very limited.

(By Paytm Money Advisory)

(Disclaimer: These are the views of Paytm Money. Investors are advised to consult their financial advisor before investing in any fund)

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