Should I shift from Large Cap funds to Index funds?

Indian large-cap mutual fund space has two prominent options. Active large-cap funds and Index Funds. And this is a discussion about Index Funds Vs. Large Cap Funds in India 2021 to decide whether should you shift from Large-cap funds to Index Funds?

Many mutual fund investors have been experiencing something odd about the large-cap funds in their MF portfolios.

Earlier, these funds used to easily beat their benchmark index. But in the last few years, the number of large-cap funds beating the index have reduced. And even the margin of outperformance of such funds have reduced.

Why is it so?

And does it mean that you should switch from active Large-Cap funds to Passive Index Funds now? We explore this debate of Large Cap Funds Vs. Index Funds in India in this post.

But first, a short primer on both categories.

What are active Large Cap Funds?

Equity mutual funds that are classified as Large-cap funds have to invest a minimum of 80% of their assets in the large-cap stocks (i.e. in the top 100 listed stocks). These large-cap stocks are also commonly referred to as the Blue Chips and represent the companies which are market leaders in their respective sectors or industries. (Read more about market cap-wise differentiation between large-cap vs mid-cap vs small-cap stocks). Now large-cap funds are active funds. That is, the fund manager decides which companies to invest in and which not to invest in to, based on his strategies but within the guidelines of having 80% of the portfolio in Top-100 stocks. Given the restrictions on large-cap funds, it may seem that most large-cap funds will have similar holdings. And that is true to a large extent. But do note that the large-cap schemes have to invest a minimum of 80% of their assets in the top 100 listed stocks. This remaining 20% can be invested in mid- or small-cap stocks as per fund manager’s choice. There are a few more points of differentiation. It is not necessary for large-cap funds to invest in at least 80 of the top 100 stocks. It’s just that it should 80% in top-100 stocks and there is a difference in that. And the difference will also be in the weights of the stocks in the fund and the index. So this too provides some scope of outperformance & downside protection based on fund manager’s ability (and differentiated strategies within the scope of the rules).

If you want to know more about this fund category, do read Where Large Cap Funds Invest in?

What are passive Index Funds?

Index funds or schemes invest in a portfolio of stocks which replicates the benchmark index. So there is no intervention by the funds manager to pick and choose stocks to invest in. Index funds are an example of passively managed mutual funds and the portfolio of index funds basically mimics the underlying index which could be a benchmark like Nifty50, Sensex, etc. These funds can pick an index to track (like Nifty 50 Vs. Nifty Next 50, Nifty Midcap 50 and other different Nifty indexes in India) and then buy stocks in the same weights as they are part of the index. So for example, an Index fund that tracks Nifty 50 will invest in all the 50 companies just like the index itself and in the same weights.

Here is the updated list of index funds in India.

To summarize, in a large-cap fund (actively managed), its the fund manager who decides which stock or sector to invest. On the other hand, an index fund will just track the benchmark index and there is no active role of the fund manager.

Since the fund manager plays an active role in a large-cap fund to pick stocks, these funds have a higher expense ratio compared to index funds which only replicate existing portfolios of the underlying index.

Apart from lower expenses, there are few other advantages of index funds as well.

No doubt an active fund can beat index funds as it can rely on its fund manager’s skill and strategy. But this may not work every year. So an actively managed fund can also underperform if the fund manager makes wrong calls (like buying wrong stocks, buying less of good stocks, buying more of bad stocks, buying too early, buying too later, selling too early, selling to late, etc.). On the other hand in an index fund, it’s just about simply mirroring the index portfolio. No active decision-making is required like in active large-cap funds.

It won’t be wrong to say that an index fund will not beat the best fund manager every year. But it will beat the bad ones very easily. And that is very important. Index funds promise index hugging returns year after year without taking the risk of fund manager getting things wrong.

And in case you are wondering which index to choose to pick the index funds, then do read Choosing between Nifty Vs Sensex for index funds.

But why suddenly this question of Index Vs. Large Cap Funds?

As mentioned at the start, the active large-cap funds used to easily beat their benchmark index in earlier years. But in recent times, the number of large-cap funds beating the index have reduced. And the margin of outperformance of such index-beating funds has also reduced substantially. That is, the excess return that active managers can deliver is reducing.

So if active funds which charge more (i.e. have higher expense ratios) are finding it tough to outperform the index, then many are questioning whether it even makes any sense to invest in large-cap funds and instead, simply pick index funds which have lower expenses. That is to say that investors don’t want to pay extra in expenses in large-cap funds which cannot beat their benchmarks regularly. And that is a fair logic at the face of it.

But why has this happened?

Why are large cap funds suddenly finding it tough to beat the index these days?

I wrote about this in 2018 itself that this was bound to happen (kind of predicted!). Do read my detailed take on this at 3 big changes to impact MF Investors in future. But to complete the discussion here, let me mention these points.

One major reason is the SEBI re-categorisation of mutual funds (2018) which has now forced active large-cap funds to invest at least 80% of their corpus in large cap stocks (top 100 stocks by market cap). Earlier these funds had the freedom to invest across a wider universe of stocks in search of alpha or good returns. With the’ 80% in the top 100 stocks’ restriction, the ability of active large cap funds to generate benchmark-beating returns has been severely impacted.

Another reason is the then mandate to shift performance reporting to TRI (Total Return Index) from the earlier PRI approach Understand it like this – when you invest, there are 2 components of the total return you can make on investments. First is of course capital appreciation, And the second is the dividends. If you only consider capital appreciation, then it means you are looking at PRI version. But if dividends are factored too along with capital appreciation, then that’s TRI – Total Returns. Naturally, the returns of a total return index will always be higher than that of a price index. The MFs also receive dividends on the stocks in their portfolios. So ideally, they should compare their performance with Total Returns Index. But earlier, they used the PRI approach instead of TRI. Let me now show how this actually impacts everything – Suppose Rs 100 invested in a fund becomes Rs 120. The PRI index of benchmark has grown from 100 to 113 in meantime. So in this case, the outperformance is Rs 7 = (Rs 120 – Rs 113). On the other hand, TRI includes dividends and hence will be higher than PRI. Suppose it is 117. Obviously, the outperformance has now reduced to just Rs 3 = (Rs 120 – Rs 117). As returns appear lower in case of a PRI, it is easier for a fund to show higher out-performance against it. So when the fund compares itself with a PRI, it shows a much higher outperformance than it is actually doing (when compared with TRI). Since the last couple of years, funds are now forced to adopt TRI and hence are finding it difficult to beat the benchmarks now.

As a result of these few things, large-cap funds are now finding it tough to beat their benchmark indices.

Earlier the active large-cap funds used to easily beat their benchmark index. But the number of active large-cap funds beating the index have now reduced. And this seems to be a clear trend for now. Also, the margin of outperformance of such index-beating active funds has been reducing.

So no doubt there is a growing case to replace active large-cap funds with passive index fund options. At least for now.

But wait.

Active funds by definition try to beat the index (or benchmark). They may succeed or they may not succeed. But an index fund does not try to beat the index. It just tries to copy it. Or in other words, index funds are to be used to hug the markets and not outperform it. So have the right expectations from index funds. Don’t expect them to beat the markets or index. They will at best, match it!

And please wait again.

There is another aspect of this discussion. And it’s important.

Concentration Risk in Index (and in Index Funds replicating Index Portfolio)

I detailed this aspect in a separate post (link). And stick with me for this for a bit. This is interesting. Something odd has been happening in recent times. The skewed weightages of few stocks in the index like Nifty50 and Sensex have created a situation that demands the question whether the Indian bellwether indexes like Sensex and Nifty50 are actually as well-diversified as they are claimed to be or not.

If you look at the Sep-2020 data of index constituents and weightages (Monthly data is available on NSE’s website here), you will notice that out of the 50 stocks in Nifty50 index:

Top 3 stocks in Nifty50 account for 32.2% weightage
Top 5 stocks in Nifty50 account for 44.0% weightage
Top 10 stocks in Nifty50 account for 62.1% weightage

And here is a list of top 10 stocks with weightages:

Reliance Industries – 14.9%
HDFC Bank – 9.67%
Infosys – 7.62%
HDFC – 6.43%
TCS – 5.4%
ICICI Bank – 5.05%
Kotak Mahindra Bank – 3.83%
HUL – 3.81%
ITC – 3.09%
Larsen & Toubro Ltd – 2.27%

This dominance of top-5 and top-10 stocks in the index is at an all-time high (or very close to it).

And that is not all from the polarization perspective. Even the sector concentration has increased a lot. In fact, as per the latest data, the combined weight of financial services, oil and gas, information technology, and consumer goods is nearly 77% of Nifty50.

It’s safe to say that more concentrated an index, the higher is its vulnerability. And that is the whole premise of having a well-diversified index that spreads the bets across various stocks and sector sufficiently well. But Indians indices like Nifty 50 and Sensex now carry (higher than ever) concentration risks because of the high weightage given to the top few stocks and sectors. Compared to indices like the S&P 500 and Nasdaq in mature markets, the problem is bigger for Indian bellwethers like Nifty50 and Sensex. Indices like S&P500 and Nasdaq have diversified their portfolio in 500 and 100 stocks respectively. But in India, Nifty has it in 50 and Sensex at even lower 30 stocks. That too skewed towards just a few top 5-10 stocks as explained earlier.

Since the index funds and ETFs in India which replicate these indices have similar portfolio composition, they too expose themselves to this risk which results in higher concentration of portfolio in just a few stocks.

Such concentration risk is comparatively lower in actively managed funds as fund managers can make their own calls to reduce exposure to stocks/sectors when they seem to be getting too large for comfort. At least he has the option to limit his exposure that is not possible in passive funds.

So in a way and to some extent, these actively-managed large-cap funds provide downside protection. Because they have the flexibility to exit or reduce exposure to stocks that are seemingly expensive or have high portfolio share.

If that is not all, then SEBI also has stipulated guidelines for mutual funds that says that the mutual funds are not allowed to own more than 10% in a single stock. After this limit is hit, the weight of a stock in a scheme can go up only to the extent of the rise in its share price. So the regulator has actually done well to put in place some rules to protect common MF investors from the concentration risk of over-exposure to few stocks, group or sector.

Note – Please don’t think that I am trying to put passive index fund investing in a bad light. I am just highlighting this gradual build-up of a new kind of risk (concentration risk) which many index investors aren’t paying heed to.

Then there is an aspect of tracking errors in index fund.

What is the tracking error (or risk) in index funds?

It’s basically the difference between the returns of an index and the index fund tracking it. That is, it’s the risk that your index fund will not match the exact returns of the index because of practical difficulties in replicating the portfolio every time. But this is more or less a manageable issue if one picks a good index fund with moderately low tracking error. If interested, you can read more about the tracking error in index investing here.

If you have to pick an index fund tracking large-cap stocks, don’t be too obsessed with the technicalities.

Keep it simple. Pick funds with large AUM, having reasonably low expenses and decently low tracking errors. That’s it. Don’t try to optimize this selection too much. It won’t help.

What about index investing in other fund categories?

Seemingly, index funds are a good option for taking exposure to large-cap stocks. But for mid and small-cap stocks, it is still better to go with active mid-cap funds and active small-cap funds. There is still sufficient scope and leeway for fund managers to show their talent and generate outperformance. For how long? I don’t know. But it’s there for now.

So while the number of active large-cap funds beating the benchmarks is reducing, it is still a good idea to have active funds in other categories like mid caps, small caps, multi-cap funds, etc. It is another matter as to whether the category itself (mid-cap funds and small-cap funds) is suitable for an investor or not.

These days, there are a lot of emotions when the debate of active vs passive comes up in India.

Most people who invest in index funds take it personally and many take the moral high ground. It is true that index funds are good options for large-cap investing. But there will always be active large-cap funds that will beat them. If you can find them and can stick with them for years, then it’s good for you. Else, you can take the index fund route easily. It’s an easy, practical all-weather approach to invest in large-cap space.

I personally follow a strategy of using a combination of actively-managed and passive index funds for my mutual fund portfolio. And what should you do?

To each his own. And it depends on one’s risk appetite, financial goals and understanding of the markets. When taking clients for Full Goal-based Financial Planning or for HNI Advisory, I review and customize their mutual fund portfolios as per their unique requirements. At times, it is enough to have passive funds. And at other times, it’s a combination of passive and active funds.

So…

Is it time to move from active funds to index funds?

To the extent of large caps, the answer is more or less yes. There is definitely space for index investing in an investor’s portfolio. But you cannot ignore active funds too (given the buildup of new risks in the index itself). There’s room for both. Taking the middle path, i.e. combination of active funds and passive funds is the way to go for most investors.

I hope you got the answer to your question of Should I invest in index funds instead of active large-cap funds? If you found the discussion useful, please share it with others who would want to know about Index Funds Vs Large Cap Funds in India (2023).