Should you still invest in large-cap mutual funds?3 min read . Updated: 23 Apr 2018, 06:42 AM IST
Just 47% of large-cap schemes outperformed S&P BSE 100 Total Returns Index over 3 years ending December 2017, and things may get tougher for them in future
If an equity mutual fund scheme gives you a return of 30% in a year, is it a good or a bad scheme? On it’s own, it looks good. But every fund is meant to compare its returns against a benchmark index, which it aims to, and should, outperform. That is the dilemma that large-cap schemes are facing these day.
Just 47% of large-cap schemes outperformed the S&P BSE 100 Total Returns Index (TRI) over a 3-year period, by the end of 2017, according to Morningstar India. In comparison, as of June 2016-end, 82% of large-cap funds outperformed S&P BSE 100 TRI. By the end of 2016, the score had dropped to 79%. Things are about to get tougher for large-cap funds.
Until now, large-cap funds have been investing in 100-200 largest companies by market capitalisation. Many such funds also invest in mid- and small-cap securities to get an extra kicker in returns. That has changed.
In October 2017, Securities and Exchange Board of India (Sebi) came out with a list of 36 fund categories and asked all fund houses to re-classify their schemes. It further defined—and tightened—the definitions of categories. A large-cap fund now is one that will invest at least 80% of its corpus in the 100 largest companies. They can invest the remaining in other stocks.
“Due to a tighter mandate, large-cap fund managers will find it tougher going forward," said Gopal Agrawal, chief investment officer (CIO)-equities, Tata Asset Management Ltd.
According to Value Research, 26 large-cap funds invested more than 20% (on an average) each in shares of small- and mid-sized companies in 2012. By 2017-end, 12 out of 62 funds invested at least 20% each in such companies.
…will pose a challenge
The dilemma of a large-cap fund is that large-cap companies are well known. According to Bloomberg estimates, at least 40 brokerage firms on an average track a company in the Nifty 50 index. Comparatively, 16 brokerages track companies in the Nifty Midcap 100 index and just nine track those in the Nifty Smallcap 100 index. “Large companies are over-researched and over-owned," said Soumendra Nath Lahiri, CIO, L&T Investment Management Ltd.
A large-cap fund manager’s true skills will be tested in how they manage the 20% of the corpus that they can invest in mid-sized companies, said Lahiri. “Sebi has given enough flexibility to a large-cap fund to move around," he added.
However, Radhika Gupta, chief executive officer, Edelweiss Asset Management Ltd, disagrees. “Funds should be run true-to-label. If this 20% of the portfolio brings about 80% of the fund’s returns, it goes against the spirit of Sebi’s re-categorisation exercise," she said.
Rajat Jain, CIO of Principal Large-Cap fund, said a restrictive mandate is not a cause of concern. “The 100-stocks universe is the same, but the number of shares we hold—and when we buy or sell them—also generates the excess performance," he said.
TRI: a higher hurdle
Effective January 2018, all equity schemes must benchmark their performances against a total returns index (TRI). All equity indices have TRI values that have dividends in underlying companies added back to the index value. The TRI indices show higher returns than the normal index values because of the added dividends. “At any given time, the TRI index is about 1.2-2.5% points more than the regular index value. Large-cap funds would need to increase their performance by that much," said Ashish Shanker, head of investment advisory at Motilal Oswal Wealth. History shows that large-cap funds, on an average, don’t beat their benchmark indices (TRI index values) by a wide margin (see graph).
Cutting the expense ratio
One way to generate outperformance over the benchmark index is to reduce expense ratios. In February 2018, Sebi had reduced the exit load charges to 5 basis points (bps), down from 20 bps earlier. It also expanded the scope of smaller towns to top 30 (from top 15 earlier) to be eligible to charge 30 bps to boost sales in smaller towns. Gupta said she cut the expense ratio of Edelweiss Large Cap fund in March 2017 from 2.6% to 1.3%. “The outperformance in a large-cap fund is not much to justify a higher expense ratio," she said.
What should you do?
We are yet to see how large-cap funds will perform in future when they face higher hurdles. But for an investor who is about to invest in mutual funds for the first time, large-cap funds are still a good way to step into equities.
For those who have been around, exchange-traded or index funds offer a better alternative as they have lower costs and give benchmark returns, while mid-cap and multi-cap funds can generate the kicker in returns. Unless, of course, large-cap funds maximise their holdings in mid-sized companies to take benefit of Sebi’s leeway.