In this blog, we’re going to solve the mystery behind investing in large-cap mutual funds and discuss why choosing passive index funds might be the smart move for you.
We’ll break down what large-cap mutual funds are, how active mutual funds function, and their performance compared to passive index funds, explaining why you might want to avoid investing in active large-cap mutual funds.
Estimated read time: 5 minutes and 16 seconds
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Buckle up. Here we go!
Before we dive into the active versus passive debate, let’s first understand what large-cap mutual funds are.
What are Large-Cap Mutual Funds?
In the world of mutual funds, funds are categorized based on the size and type of companies they invest in.
Large-cap mutual funds, also known as blue chip funds, primarily invest in the stocks of the top 100 listed companies, as defined by their market capitalization. These companies are often leaders in their respective industries, known for their stability and consistent growth.
As per SEBI regulation, large-cap funds must invest at least 80% of their assets in these 100 companies.
Active vs. Passive Mutual Funds
Active Mutual Funds: These funds are actively managed by professional fund managers who make investment decisions intending to outperform a specific benchmark index, such as the Nifty 50 or the Sensex. The idea is to pick stocks that will generate higher returns than the index (alpha).
Passive Mutual Funds: Passive funds, on the other hand, don’t rely on active decision-making by fund managers. Instead, they aim to replicate the performance of a specific index. These funds simply mirror the composition of the chosen index. If the index goes up, the passive fund goes up. And if the index goes down, so does the passive fund.
If you want to learn more about active and passive mutual funds, read here.
Now, let’s dive into the numbers because when it comes to your hard-earned money, facts and figures are your best friends. Let’s look at how active large-cap funds have fared against passive index funds over the years.
Performance: Active vs. Passive in Large-Cap Category
Historically, active large-cap mutual funds have been a popular choice for investors seeking potentially higher returns. The allure of having experienced fund managers make decisions on your behalf can be appealing. However, the data tells a different story.
Reports show that over the long term, most active large-cap mutual funds in India have struggled to consistently outperform their benchmark indexes. Over a 5-years timeframe, 92.9% of active mutual funds failed to beat the index in the large-cap category.
Though it looks like active managers produced relatively better results over the 10-year timeframe, with the underperformance rate dropping to 61.2%, this data can’t be relied on in this case. Because maximum large-cap funds were not benchmarked against the TRI (total return index) before 2018.
Before the re-categorisation of mutual fund schemes in 2017, many large-cap funds had higher exposure to mid-cap stocks, pushing their returns up. Post-2017, large-cap funds were mandated to invest only in the universe of 100 top stocks by market capitalisation.
This isn’t to say that there aren’t exceptional fund managers who can beat the market, but the challenge lies in finding them. And even though some funds may outperform in a particular year or two, maintaining that outperformance over extended periods is a rare feat.
Why Do Active Mutual Funds in the Large-Cap Category Fail to Beat the Index?
Several factors contribute to the underperformance of active large-cap mutual funds compared to passive index funds. Here are some key reasons:
- Maturing Market: Increased efficiency and market transparency have made it progressively more challenging for fund managers to find undiscovered value and generate alpha.
- Fees and Expenses: Active funds typically charge higher fees and expenses as they involve active management. These costs can eat into your returns, making it more challenging for active funds to outperform passive ones.
- Behavioural Biases: Fund managers are also prone to behavioural biases, such as overconfidence or loss aversion, which can lead to suboptimal investment decisions.
- Portfolio Churning: In their quest to beat the index, fund managers often engage in frequent buying and selling of stocks. This high turnover can result in increased transaction costs and taxes, negatively affecting your returns.
- Lack of Consistency: It’s challenging for active fund managers to consistently pick winning stocks year after year. Market conditions change, and what worked well in the past may not work in the future.
The Passive Alternative: Large-Cap Index Funds
Given the challenges that active large-cap funds face, many investors are turning to passive alternatives, such as Nifty 50 Index Fund and Nifty Next 50 Index Fund. These funds aim to replicate the performance of a specific index, like the Nifty 50 or the Sensex 30.
Here are some reasons why passive large-cap index funds might be a better choice:
- Lower Costs: Passive funds have lower fees and expenses. This means you get to keep a more significant portion of your returns.
- Transparency: With passive index funds, you know exactly what you’re investing in, as the holdings mirror the benchmark index. This transparency can help you make informed investment decisions.
- Predictable Performance: Passive funds aim to replicate the performance of the index, so your returns closely mirror the index’s performance, minus the fees and tracking error. There are no surprises or unpredictable results.
- Consistency: Index funds don’t suffer from the inconsistencies that active funds may experience. They offer a stable and steady investment option.
- Minimal Involvement: Index funds require minimal involvement and oversight. If you’re looking for a “set it and forget it” approach to investing, index funds fit the bill.
When Should You Invest in Large-Cap Index Funds?
Investing in equity large-cap index funds can be a wise choice for many investors, particularly those seeking a balance between growth potential and lower risk. Here are some conditions and scenarios in which you should consider investing in large-cap index funds:
- Long-Term Investment Horizon: Large-cap index funds are best suited for investors with a long-term investment horizon. If you’re planning to invest for 5 years or more, large-cap funds can be a stable and consistent choice.
- Risk Aversion: If you are risk-averse and prefer a more stable and less volatile investment option in equity, large-cap index funds are a good fit. Large-cap stocks are typically less volatile compared to mid-cap or small-cap stocks.
- Diversification: Large-cap index funds offer automatic diversification across a wide range of established, well-known companies. This diversification helps spread risk and reduce the impact of poor performance by any single company.
- Market Stability: During times of market volatility or economic uncertainty, large-cap stocks often provide more stability. If you want to stay invested in the market while minimizing downside risk, large-cap index funds can be a good option.
Do you want to know how to pick the best passive/index fund? Read here.
Also, it’s important to note that while large-cap index funds offer many advantages, they may not provide the same level of growth potential as mid-cap or small-cap funds.
If you’re comfortable with higher risk and are willing to take a more active approach to your investments, you might consider a blend of large-cap and other categories to diversify your portfolio further. Let us know if you want us to cover other mutual fund categories. Tweet at us.
Final Thoughts
In the world of mutual funds, the choice between active and passive funds can be confusing. When it comes to large-cap mutual funds, the data suggests passive index funds may offer a more straightforward and potentially more rewarding path for investors.
While there are certain exceptions, most active large-cap funds struggle to consistently outperform their benchmark indexes over the long term. This underperformance, coupled with higher fees and other associated costs, can erode your returns significantly.
Investing in passive large-cap index funds allows you to access the potential growth of large-cap companies in India with lower costs and greater transparency.
For beginners looking to get started with mutual funds, this approach simplifies the investment process and aligns with a long-term, low-maintenance strategy. It’s an easy way to get started without delving deep into the complexities of stock picking or navigating the unpredictable waters of active mutual funds.
Share these insights with your buddies. Until next time!
Still Curious?
If you are like us, who likes to analyse a little more or check out content in different formats, well you are in luck. Below you can find some suitable content we found.
S&P Global – SPIVA India Mid-Year 2023 Scorecard
The Economic Times – 5 large cap mutual funds completed 25 years. Here’s how they performed
Note: We don’t have any affiliation with them. We are sharing links only for educational purposes. The opinions expressed by them belong solely to them and do not reflect the views of Vrid.