Passive or active allocations: What suits your large-cap investing?

Large-cap fund allocations figure in almost all investor portfolios as there is a comfort of known companies, management style, good research coverage and information dissemination. Also, as they are seemingly less prone to wild swings in their stock prices, they are perceived to be less risky. As a result, large-caps allocations are considered relatively ‘conservative’ equity investment than either small-caps or mid-caps. However, choosing the correct approach in fund investing —active fund or passive fund—is an important factor in deciding on the investment in large-cap funds. Therefore, a few key points will have to be taken into consideration.

Overlapping risk: A wolf in sheep’s clothing

When determining the investment approach for large-caps, be it active or passive, one must analyse the overlapping factor which is an unavoidable constant in the dynamic world of large- cap funds. Data suggests that 73% of the large-cap funds have 40-60% overlapping. Some overlap is a given in the large-cap world, but excessive overlap reduces all the benefits one can get from excess diversification, irrespective of whether the approach is active or passive.

When you invest in multiple funds from the same large-cap universe without realizing the consequences, there is a high chance of an overlap of a few stocks. And if these stocks perform negatively, all the funds in the portfolio will also deliver negative performance. The aim of diversification is to spread risk. Since the large-cap universe is a relatively small one, overlapping is one of the major issues. Hence, one should be mindful of the risk and accordingly diversify in their choices of funds and mitigate that risk whatever approach they take, either active or passive.

Active share: earning their salt – top quartile funds

Large-cap funds must invest 80% of the corpus in large-caps. Active mutual funds rely on the fund manager’s expertise to select the best large-cap stocks. However, only having a high active share is not enough. They also have to outperform their benchmark indexes as well. In the universe of large-cap funds, generally top of the curve, the past seven-year performance of active share approach in large cap mutual funds gives an idea as to how they have shown constant growth and delivered better results.

Data of rolling returns suggests that top quartile large cap funds have beaten the index 100%, 84% and 66% over a 7-year, 5-year and 3-year period, respectively. Hence, the choice of funds and the ability to identify top quartile funds is crucial.

Large cap investing options

As the large-cap universe is a relatively limited one to create additional alpha and for investors who are comfortable with a low active share, passive funds have a case in point. Some of the key benefits of passive funds are that they simply follow the index they use as their benchmark and have lower expenses. Hence, if one is looking for cost effective investment approach, and have low active share then they can opt for passive funds.

Another option in the active space could be flexi-cap fund, an open-ended, dynamic equity scheme. It helps by providing investor a good hunting ground and lets them diversify their portfolio by investing in firms with varying market capitalizations. Because, the universe here is huge and not limited to large caps. The additional ground offered by mid- and small-cap funds gives the fund manager the freedom to take his call without many constraints.

When deciding on the investment approach for large-cap funds, one must consider things from every perspective by evaluating overlap holdings, expense ratio, active share benefits, passive fund sustainability and flexi-cap choices. One must keep everything on the table and analyse the pros and cons of active and passive share approach. The risk each of them carry and the returns they allow should be taken into consideration to make a wise decision.

Girish Latkar is partner and co-founder, Upwisery Private Wealth.