Large Cap Mutual Funds: What is their source of outperformance?

Published: August 19, 2017 at 11:33 am

Last Updated on August 21, 2017

In this post, I discuss why it is important for investors to not take mutual fund market cap classifications seriously. In particular, your “large cap fund” is probably either a multi-cap fund all the time or now and then. The notion of what is a giant cap, large cap, mid-cap, small-cap or micro-cap stock is not set in stone. Each analyst has their own definition and it is common to see a fund hop categories.

Unfortunately, mutual fund houses are not bound by any classification rules. They deliberately make the scheme objective as broad as possible so that they have freedom to maneuver and beat the benchmark. How they do so is another matter. This is of course, true in many areas. For example, when I ask my Ph.D. student to define her thesis problem, I will tell her not to be specific as we cannot justify a change later.

The point is that fund houses are perfectly right in doing so. Our problem is that we take rating portals too seriously. They are only good enough as a source of raw data, but we go by their fund classifications and many get swayed by star ratings.

Large cap fund market cap vs last 1Y return

A fund market cap is a measure of the nature of stocks in the portfolio. Higher the large cap stocks, higher the funds market cap. The market cap of “large cap” funds (blue) is plotted against their last 1Y return.


The index funds and etfs are inside the black box. Notice how significantly the market cap of active large cap funds deviates! So they are not truly large cap in that sense! Also, notice how the returns increase as the deviation increases. This is of course because of the returns in the last 1Y in the mid-cap and small-cap segment.

Many index fund fans make a song and dance about this: “outperformance comes only because of investing in other caps”.

Well, I am not too worried about this. The problem lies in placing such a wide variety of investment strategies in the same bin and labelling it as large cap. Yet another reason why star ratings are nonsense.

Large cap fund market cap vs last 3Y volatility

Now I replace the 1Y return with the standard deviation. This is a measure of volatility and is calculated by finding out the deviation from the average of monthly returns taken over the last 3Y.

Notice that higher the deviation from the index fund market cap, higher the volatility. The data point that sticks out (black circle) belongs to fund of fund with an impressive track record:  ICICI Prudential Advisor Series – Very Aggressive Plan. Of course, in our obsession with returns and saving tax, we tend to ignore gems like these. It has only a few Crores as AUM. When investors lack logic, why blame mutual funds for chasing “alpha”?!

Large cap fund market cap vs Sortino Ratio (3Y)

Now let me replace the standard deviation with the Sortino ratio. These measures are faulty and technically should be avoided (and therefore star ratings), but I would like to fool around with them for some fast-food analysis. Feel free to ignore.

The Sortino ratio = (fund return – risk free return)/(volatility due to negative returns).

Higher the Sortino ratio, the better.

Active funds do have better Sortino ratios than index funds. In my opinion, this justifies the management fees (of direct plans). Again the fund that sticks out (~ 3.5) is the ICICI fund mentioned above.

The source of large cap fund outperformance may be deviations from the large index market cap. However, the active management does come with more than reasonable risk protection.

What should investors do?

1: Use star rating portals for raw data and not for their opinions.
2: Study scheme documents and understand where the fund can invest and not go by portal classifications.

3: Check if the fund is providing you with downside protection for the fees that they charge. This is more important than returns.

4: Consider funds like Quantum Equity Fund of Funds or ICICI Prudential Advisor Series (it has different plans) as turnkey solutions to beat inflation. So you have to pay a little extra. So what? No one died because they paid more taxes.

5: Recognise that as long investors are immature and seek returns, fund houses will strive to satisfy them by straying more and more from their designated benchmarks*. This is true for both equity and debt funds.

  • The designated benchmark itself is an often a farce. They choose benchmarks which are easy to beat.

Unless the regulator defines category bins and unless they insist a minimum overlap with a benchmark at all times, such deviations will continue.

As long as we understand what the fund is doing, such deviation need not be harmful.

How about mid-cap and small -cap funds?

In the mid-cap space, the arrow below denotes the market cap of Motilal Oswal MOSt Shares M100 ETF Fund that tracks the Nifty Free Float Midcap 100. The returns are all over the place. So I am not too motivated to plot the risk stats.

There are not enough small cap funds to say much.

_______________________________

Ask Questions with this form

And I will respond to them in the next few days. I welcome tough questions. Please do not ask for investment advice. Before asking, please search the site if the issue has already been discussed. Thank you.  PLEASE DO NOT POST COMMENTS WITH THIS FORM it is for questions only.

[contact-form][contact-field label=’Name’ type=’name’ required=’1’/][contact-field label=’Email’ type=’email’ required=’1’/][contact-field label=’Comment’ type=’textarea’ required=’1’/][/contact-form]

GameChanger– Forget Startups, Join Corporate & Live The Rich Life You want

My second book, Gamechanger: Forget Start-ups, Join Corporate and Still Live the Rich Life you wantco-authored with Pranav Surya is now available at Amazon as paperback (₹ 199) and Kindle (free in unlimited or ₹ 99 – you could read with their free app on PC/tablet/mobile, no kindle necessary).

It is a book that tells you how to travel anywhere on a budget (eg. to Europe at 50% lower costs) and specific investment advice for young earners.

The ultimate guide to travel by Pranav Surya is a deep dive analysis into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, how travelling slowly is better financially and psychologically with links to the web pages and hand-holding at every step.  Get the pdf for ₹199 (instant download)

You can Be Rich Too with Goal-Based Investing 

My first book with PV Subramanyam helps you ask the risk questions about money, seek simple solutions and find your own personalised answers with nine online calculator modules.

The book is available at:

Amazon Hardcover Rs. 271. 32% OFF

Infibeam Now just Rs. 270  32% OFF. If you use a mobikwik wallet, and purchase via infibeam, you can get up to 100% cashback!!

Flipkart Rs. 279. 30% off

Kindle at Amazon.in (Rs.271) Read with free app

Google PlayRs. 271 Read on your PC/Tablet/Mobile

Now in Hindi!

Order the Hindi version via this link

Do share if you found this useful

We now publish both equity fund and debt fund (+ hybrid fund) screeners each month!
Use our Robo-advisory Excel Template for a start-to-finish financial plan! Now with a new demo video!  More than 415 investors and advisors use this!
Unlock the secrets of successful financial advisors and entrepreneurs with our new course!
My new book for kids: “Chinchu gets a superpower!” is now available!
Both boy and girl version covers of Chinchu gets a superpower
Both boy and girl version covers of Chinchu gets a superpower.
Most investor problems can be traced to a lack of informed decision making. We have all made bad decisions and money mistakes when we started earning and spent years undoing these mistakes. Why should our children go through the same pain? What is this book about? As parents, if we had to groom one ability in our children that is key not only to money management and investing but for any aspect of life, what would it be? My answer: Sound Decision Making. So in this book, we meet Chinchu, who is about to turn 10. What he wants for his birthday and how his parent’s plan for it and teach him several key ideas of decision making and money management is the narrative. What readers say!
Feedback from a young reader after reading Chinchu gets a Superpower (small version)
Feedback from a young reader after reading Chinchu gets a Superpower!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.
Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Did you know? We have more than 1000+ videos on YouTube to explore! Join our YouTube Community!

Join our courses in exclusive Facebook Groups!

  • 550+ members are now part of our new course: How to get people to pay for your skills! (watch 1st lecture for free). Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show how to achieve by showcasing your skills and building a community that trusts you and pays you!
  • Goal-based portfolio management! Join 2220+ members and get clarity on how to plan for your goals and achieve the necessary corpus no matter what the market condition is!! Watch the first lecture for free!  One-time payment of Rs. 3000 only. No recurring fees! Life-long access to videos (10+ hours content)  in an exclusive Facebook Group! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.

Want to check if the market is overvalued or undervalued? Use our market valuation tool (will work with any index!), or you buy the new Tactical Buy/Sell timing tool!
We publish mutual fund screeners and momentum, low volatility stock screeners .every month.
About the Author Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations based on money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association, IIST Alumni Association. For speaking engagements, write to pattu [at] freefincal [dot] com
About freefincal & its content policy Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on developments in mutual funds, stocks, investing, retirement and personal finance. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than one million readers a year (2.5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified from credible and knowledgeable sources before publication. Freefincal does not publish any paid articles, promotions, PR, satire or opinions without data. All opinions presented will only be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
Our publications

You Can Be Rich Too with Goal-Based Investing

You can be rich too with goal based investingPublished by CNBC TV18, this book is meant to help you ask the right questions, seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now. It is also available in Kindle format.
Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want Gamechanger: Forget Start-ups, Join Corporate and Still Live the Rich Life you wantThis book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.

Your Ultimate Guide to Travel

Travel-Training-Kit-Cover-new This is an in-depth dive analysis into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, how travelling slowly is better financially and psychologically with links to the web pages and hand-holding at every step. Get the pdf for Rs 199 (instant download)
Free android apps