Should I now switch from large cap funds to index funds?

Published: September 28, 2018 at 9:32 am

Last Updated on February 12, 2022 at 6:19 pm

So a question on many lips is, “Should I now switch from large-cap funds to index funds?” the reason being the new rule about large-cap funds that 80% of their portfolio should be from the top 100 stocks in terms of full market capitalization (that is from the NSE 100). In this post, I discuss this question using data from the September 2018 Equity Mutual Fund Performance Screener and from data published in April 2018: Warning! Nifty Next 50 is NOT a large cap index!

First of all, it is a little premature to assume that just because a large-cap fund has to be invested in 80% of large-cap stocks as defined above, it does not mean that the funds cannot beat Nfity 100 Total returns index or Nifty 50 Total returns index (the typical benchmarks). It is important to recognise that these funds do not need to invest in 80 of these 100 stocks. Even if they do, their weights in the fund will be different from that in the index and that alone is enough to provide downside protection and outperformance. In addition, the remaining 20% can be in midcaps or small caps and this can drive higher returns. So if you want to switch to index funds, make a decision based on facts and not conjecture. Look at the performance of your fund and check using the freefincal screener how the category is doing as a whole.

Second of all, just because SEBI says the top 100 stocks in terms of market cap are “large-cap” does not make them so! You will now see the Nifty Next 50 index listed as a large cap with a five-star rating. It is a hugely volatile fund with a risk equal to that of midcaps. So if you do want to switch to index funds, be very careful when you choose nifty next 50. It is a fine index but not a large-cap index. You need to be aware of what you are getting into.

Third of all, do not switch to index funds hoping all active funds will fail. That sort of expectation is wrong and will only leave you unhappy if you do see funds (esp the ones you exited) do well later. Switch to index fund only if (1) you are tired of paying high fees and then worrying about performance (2) tired of worry about peer performance (3) tired of worrying about what the fund manager is doing (4) and what if they exit. By choosing an index fund, you can be a no-fuss, no-frills investor, with enough time to focus on your asset allocation, risk management and your target corpus.

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Fourth of all, looking at returns alone and costs alone is immature. When index falls by -10% over a month, an actively managed fund ought to fall by less. This will keep the investor calm. Most investors I see every day are not mature enough to understand this or know enough to manage risk on their own. Unfortunately, even in an actively managed fund, the risk has to be managed so they have no choice but to learn. One viable option is to Using Balanced Mutual Funds As The Core Equity Portfolio Holding. Here the fund managers fee is reasonably justified and there are no hybrid index funds in India as of now. The overall risk will be lower. See – Balanced Equity Funds: the low risk, high reward option. Here too simple Steps to De-risk Your Investment Portfolio are essential.

So this is a taping of a talk I gave on index investing options in India. Do take a look if you are new to this sort of thing. Since I have been talking so much about the index, I opened up a category and you can access the full archive of indexing posts

So now let us get to the data. In my monthly screeners, I use Nifty 100 Equal Weight index (N100EW). This contains all 100 stocks in equal proportion unlike the Sensex or Nifty 50 (N50) or Nifty next 50 (NN50) of Nifty 100. These indices provide the maximum weight to stocks with the largest free float market cap. So this offers a nice way for the fund manager to outperform the index. So to answer, Should I now switch from large-cap funds to index funds? have taken the large-cap funds with a star rating at Value Research and compared their performance with N50, N50EW, N100 and N100EW.  Regular users may be aware that I usually use N100EW as the category benchmark for large-cap funds.

Should I now switch from large cap funds to index funds?

So we now have 46 funds to being with. However, 20 of these are index funds and ETFs and these have been removed. We only consider direct funds over every possible 5-year period from Jan 2013 onwards.

Large-cap funds vs Nifty 50

Only 4out of 26 active funds failed to beat N50(total return) 80% of the time or more. This means that if we consider 100 5Y return periods, 22 funds beat N50TRI at least 80% of the time. In fact, 21 beat it 100% of the time and one fund 98% of the time.

Out of those 22, 12 funds protected investors from downsides at least 80% of the time. So don’t be in a hurry to ditch your active large cap for the Nifty 50.

Large-cap funds vs Nifty 50 Equal Weight

Only 1 out of 26 active funds failed to beat N50EW (TRI) 80% of the time or more. In fact, 25 funds have 98% plus outperformance consistency. Six out of 26 funds had a downside protection consistency less than 80%. So again, don’t be in a hurry to choose Nifty 50 EW.  Amusingly 6 out of 14 Nifty and Sensex index funds beat N50EW 80% of the time or more!! Only 6 out of 14 because of the impact of expenses!

Large-cap funds vs Nifty 100

Things change when we expand to Nifty 100. Only 16 out of 26 active funds beat N100 TRI 80% of the time over the 5-year periods considered and remember this was before the SEBI recategorization. Only 6 out of those 16 have a downside protection consistency of more than 80%This is what Avinash referred to in his article yesterday: Avoid mistakes & minimize costs through index funds: Don’t waste energy fighting the law of no-free-lunch (however these results are not as bad in the S&P report quoted).

The problem here is that you cannot know beforehand if your chosen fund will outperform N100 or not. So the only logical choice is to avoid active funds and choose N100. However, there are no index funds tracking the N100. Only 4 ETFs are available (other than Edelweiss N100 Quality 30 ETF) and these have either poor AUM and/or huge price-NAV difference. LIC has 328 Crores in its N100 ETF but check out how bad the price-nav difference is! Stay away from N100 until you have an index fund option

Large-cap funds vs Nifty 100 Equal Weight

I have already pointed this out last month: Will large-cap mutual funds struggle to beat Nifty 100 Equal Weight Index? This is a hard index to beat! As on Sep 2018, only 9 out of 26 active funds have 80% outperformance consistency record against this index. Most funds (230 have very good downside protection record of >=80%, but this maybe cold comfort for most investors.

Fortunately, at least as of now, there are two index funds (one from Sundaram and one from Principal) tracking the N100EW and I think they can be used. This is the reason why I included them in my list of Handpicked Mutual Funds September 2018 (PlumbLine)

What about Nifty Next 50? Please see the results in this post: Warning! Nifty Next 50 is NOT a large cap index! This is an extremely volatile index with midcap-like risk. Beware.  I attach below one image from this post which tells you the N100EW is a better choice than N100, N50 or N50EW, or the NN50. Read the post for details.

NIfty 100 equal weight N50 vs NN50 - Warning! Nifty Next 50 is NOT a large cap index!

The N100 has a risk similar to the N50 and marginally higher reward (not all the time though). The N1ooEW is a higher risk, (potential) higher reward option compared to the N50. It is a lower-risk, (potential) comparable reward wrt NN50.

Should we switch from large-cap funds to index funds?

The evidence is clear. Even with N100, it may be difficult to find large-cap funds that can outperform. So indexing is an obvious choice for the mature investor who will not judge funds based on a few days performance, who will not see the portfolio every day, will not be swayed by what they read in the media or blogs (like this junk post), will not take star ratings seriously etc.

Since all investors worry about returns, about expenses but most investors do not fit the above profile, an alternative is to use balanced Mutual Funds As The Core Equity Portfolio Holding instead of large caps. For better or worse, my portfolio is based on this: This is my portfolio vs Sensex, Nifty Next 50: Want to Check yours?

To be frank, I have been considering N100EW for myself. I have not decided yet. If you want to switch to an index fund, do so gradually when the current NAV is lower than the NAV on Jan 31st 2018. That way, your LTCG will be tax free. Don’t be in a hurry to switch though. Have a proper plan. If you have not yet thought about asset allocation and how to change it, Download the Freefincal Robo Advisory Software Template and give it a try this weekend.

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Pattabiraman editor freefincalDr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.
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