Is it time for you to shift from large-cap to passive mutual funds?

Posted on by KNBT

The return advantage shows in large-cap funds if you pick good managers and remain invested through cycles. Photo: iStock

The return advantage shows in large-cap funds if you pick good managers and remain invested through cycles. Photo: iStock

If you are a mutual fund investor, you would have noticed that your large-cap funds are struggling to beat their benchmark performance over one to two years. This means they are not giving a return over and above the average market return as tracked by an index. You may be aware that your mutual fund scheme charges you 2-3% per annum as fees, a chunk of which goes as investment management fee, your returns are calculated after accounting for this. If there is no outperformance against a market index, then paying such fees starts to feel wrong.

The alternative that has gained popular opinion over the last few months are passive funds or those in which there is no involvement of a fund manager and, hence, no investment management fees. The portfolio mimics an underlying index, which could be the benchmark that other funds are trying to beat. The returns from these are very close to the index returns, save for some administrative fees. Exchange-traded funds (ETFs) are a type of passive fund where fees are much lower at 0.01-1% per annum.

Is it time for you to consider moving your large-cap exposure to passive funds? Before concluding, let’s compare how managed funds have performed against passive funds like ETFs for longer periods, such as 5 and 10 years, to ascertain whether declining outperformance is indeed a trend.

What does data say?

To analyse the underperformance of actively managed large-cap funds versus passive funds, we looked at historical returns for the last 10 years. In that, we compared the average 10-year annualised rolling returns for each calendar year from 2008 till date.

Here is what we found. The excess return that active managers can deliver is reducing. However, look deeper and you’ll find that in each year there were several active funds that outperformed the index and other funds that were severe underperformers.

Also read: Top mutual fund schemes to invest in

Let’s take the year 2012: Nifty ETF delivered an average 10-year rolling return of 19.18% annualised. This compares to an average 22.8% annualised 10-year rolling return for the large-cap actively managed category, within which the best performing fund delivered an annualised return of 28.02% versus 11.2% for the worst performing fund. The top performer has beat the ETF by around 8.8% annualised return over a 10-year period. That is a significant outperformance, which cannot be ignored.

Let’s cut to year 2017: the average 10-year rolling return for the best performing large-cap fund was 12.99% annualised and the worst performer came in at 3.57% annualised return. Similar period performance for the entire category was an average of 9.42% annualised and for the Nifty ETF 8.44% annualised return. The excess return of the best performer versus the ETF was at around 4.5% annualised for a 10-year period; still a significant outperformance but undoubtedly the gap is shrinking.

Will the trend continue? 

Several reasons have contributed to this trend over the last 10 years. Firstly, the size of assets managed under equity funds has increased significantly. Ten years ago the cumulative assets in equity-oriented schemes was around ₹1.3 trillion as compared to nearly ₹8.8 trillion today. There is more money chasing a limited set of stocks.

According to Nilesh Shah, managing director, Kotak Asset Management Co. Ltd, “There are multiple reasons for this trend. Managing a small-sized fund for generating excess return is easier than from a very large fund; sizes have increased manifold over the years. Information asymmetry for large-cap stocks is practically nil making it harder to generate excess returns. Within the benchmark too, stocks which deliver returns are far more concentrated than before.”

Globally, there is a shift towards ETF-based investing, which has picked up significant force in emerging markets too.

According to Anand Radhakrishnan, chief investment officer- Franklin equity – India, Franklin Templeton Asset Management (India) Pvt Ltd, “There is a change in the nature of global flows which looks for beta (return from market movement) exposure through ETFs. This low-cost exposure is also agile, it can come and go very quickly. This is one of the primary reasons why the big (stocks by market capitalisation) are getting bigger.”

With the recategorisation of mutual fund schemes, the Securities and Exchange Board of India has now defined the set of stocks that are to be included in large-cap funds. This standardisation across schemes will mean an even larger pool of money will chase a very limited and defined number of stocks.

Radhakrishnan is not too concerned. “This change (adherence to guidelines) will bring down the divergence between funds, but still the leeway to have up to 20% in mid-cap will help. The changes in the nature of flows into equity is a greater problem, thanks to which timing related excess return is perhaps a thing of the past,” he said.

What should you do ?

One school of thought is that large-cap funds will have to reduce their fees to compensate for the performance. We are already seeing that happen in select schemes.

However, not all agree that fees are the only way to go. “Price change is the easier solution; we must consider innovating in other ways. One solution could be to have portfolios and strategies which are more concentrated and better placed for delivering return above the benchmark. Introduction of long-short funds and enabling funds to take leverage are also ways to think about. Expenses will continue to come down, the idea should be to try and improving returns through actively doing other things,” said Shah.

Innovation in products can benefit, provided investors can assess the changing structures and risks attached. Your ultimate tool for now is to carefully filter out individual schemes. There is merit in investing in consistent outperformers even in the large-cap category. The return advantage shows up if you pick good fund managers and remain invested through cycles. If you can’t take the time out for this or are unable to get an adviser to help, then ETFs are a better choice.

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