Large cap vs. Index funds - do you need to choose?
TLDR: Are large cap funds still relevant post SEBI re-categorisation environment and do they compare favourably against index funds?
Most new investors are typically open to taking baby steps in the mutual fund space. Either because they don’t know much about the markets or they are fairly conservative and have considered stocks and stock investments to be risky. The gateway drug to entice them is bluechip or large cap funds. Most fund houses can convince investors to invest in the likes of Reliance, Infosys, TCS, ITC via a large cap fund rather than a mid-cap or small cap fund with relatively unknown companies.
Fund houses had two tricks up their sleeve when it comes to generating good returns compared to SENSEX or NIFTY the two benchmark indices for large caps.
Throw in a few mid caps into the portfolio mix - Even though these funds are categorised as large cap funds, they fund manager goes ahead and adds a few rising stars in the mid cap space to boost the overall return
Benchmark against NIFTY and not NIFTY TRI - Until recently most of the benchmarking of the large cap funds was against NIFTY index and not against NIFTY TRI (Total Returns Index). The TRI includes the return calculated including all the dividends issued by the index components as a part of the overall return calculation. This is an important distinction I will cover later in this post.
These two tricks allowed bluechip and large cap funds to “beat” the index. But all of this changed in 2017/18 when SEBI incorporated some additional restrictions on how funds will need to classified and how they need to be benchmarked.
Fund re-categorisation
SEBI enforced some strict guidelines on the fund categorisation based on the fund classification, details in the below article. but i would like to highlight one particular paragraph.
“The matter goes back to October 2017 when SEBI came out with the guidelines for categorisation of MF schemes. Large cap MFs, it said, were those which invested only in the top 100 companies in terms of market capitalisation.”
https://www.thehindu.com/business/Industry/sebi-and-mf-norms/article26063522.ece
This essentially plugged the sneaky way by which large cap funds boosted their performance by including some mid cap stocks into their portfolio.
Benchmarking against TRI
The first step was forcing the benchmarking of funds against the index TRI which include the dividend returns as a part of the calculation of total returns.
Source : https://nifty-pe-ratio.com
On average the dividend yield of NIFTY is around say 1.5%, this might not appear like a big difference, but let me prove otherwise.
Assume that you are doing an SIP on the NIFTY index for a reasonable sum of 25,000 every month over the last 10 years
Assume average return on NIFTY is 13% over the last 10 years without considering the dividends. So with dividends the return would be 14.5%.
Assume that the dividend is reinvested, let us see how the returns are at the end of 10 years comparing the two.
Link to spreadsheet - Close to 10% difference in the value of the portfolio.
How has both these factors impacted fund performance and return over the last year?
Impact on large cap funds
Of 57 large cap direct plans funs that I could pull out, there is just one fund in the top 10 performing which is not a SENSEX or NIFTY fund. Almost all of the actively managed funds are in the bottom of the list. The top half is dominated by index funds. The top 25 funds by performance listed below.
Link to spreadsheet for list of all 57 direct large cap funds.
Advantage of index funds
When it comes to large cap, investing directly via a low cost index fund is clear winner. Typically expense ratios of index funds are much lower than actively managed funds and there is reduced churn of the portfolio compared to actively managed funds there by reducing the trading costs as well.
Conclusion
Given that index funds replicate the index, it takes the guess work out of choosing the fund house and related research. Pick a fund that has the lowest expenses and minimal tracking error. I recommend UTI Nifty and NIFTY next 50 index funds.
Do you see the need to invest in large cap actively managed funds? Or are you switching to low cost index funds on NIFTY and NIFTY next 50 instead? Leave your comments below.
Happy Investing
