Is time ripe to replace your Largecap Fund with an Index Fund?

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There is nothing new about the index funds versus active mutual funds debate. It has been a contentious subject for years with powerful believers on both sides. It is clear in US that majority active funds have under-performed passive funds and hence, there is a big shift that has begun to happen from active mutual funds to passive index funds and ETFs. As on Dec 2018, 82% of largecap funds in US have underperformed the S&P 500 index over last 5 years.

Passive investing is overtaking active investing in the US. Passive Mutual funds and exchange-traded funds that track indexes now hold 48 percent of assets, according to estimates from Morningstar. They’ll top 50 percent in 2019 if the current trend holds. That would mark a tipping point for the investing industry, which for decades built its image on the art of stock picking seeking to beat the markets. In recent years, investors have abandon those active managers in favor of ETFs and other index funds, which typically offer a way to get market exposure at far lower fees.

Passives taking over active funds in the US:

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Active Funds have been underperforming broader benchmarks across the globe. Be it emerging markets like Brazil, India and South Africa or developed markets like USA, Japan and Europe, all of them are showing trends where active funds are struggling to beat passives.

% of Largecap Funds/Equity Funds underperforming Index
Country 1 year 3 year 5 year
USA Largecap Funds 64% 79% 82%
Canada Equity Funds 93% 91% 90%
Brazil Equity Funds 56% 85% 84%
Europe Equity Funds 59% 63% 74%
South Africa Equity Funds 84% 86% 89%
India Largecap Funds 92% 91% 58%
Japan Equity Funds 84% 57% 59%
Australia Equity Funds 87% 86% 80%
Data Source: Dec 2018 SPIVA report by S&P

India too catching up slowly…

Coming back to India, the debate over active vs passive funds has heated up in recent years, particularly in the largecap fund category. As per the latest SPIVA report by S&P, India too is showing the trend where active funds are underperforming passives. Particularly in the largecap space. With 92% largecap funds underperforming S&P BSE 100 index in last one year and 64% largecap funds underperforming in last 10 years, the situation is gloomy for large cap funds. While categories like multicap, midcap and smallcap funds have displayed decent outperformance during the same period, largecap funds clearly shows the struggle.

Percentage of active funds underperforming the index:

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What does this mean for largecap funds?

Largecap funds in India may continue to struggle in outperforming their benchmark. Some of the important reasons which will contribute to this struggle as are follows:

Shrinking universe and information edge: The new SEBI scheme categorisation mandates active largecap funds to invest minimum 80% of their portfolio in top 100 stocks. This restriction can make fund managers life difficult. Most Fund Managers don’t have any information edge while researching these stocks. This makes it difficult to hunt for alpha in these stocks unless they take very skewed bets in these stocks compared to their weights in the index. The remaining 20% can be invested in midcap and smallcap stocks, but large size funds may have to restrict higher concentration in these midcap and smallcap stocks due to lower liquidity that they offer. Smaller largecap funds may still invest in them and generate some alpha.

Higher fees: Average fees charged by largecap funds is over 1.8%. Such high fees in a category where alpha generation is difficult plays a dampener.

Over Diversification: Average number of stocks a largecap funds holds is over 50. Such high diversification leads to owning the market and if you own the market it is difficult to beat the market. Many largecap funds hug the benchmark to reduce risk of underperformance in the short term which again makes it difficult to outperform the index. Focused largecap funds may still be able to beat index as they take concentrated bets and go for wider deviation in terms of sector exposure compared to a normal diversified largecap fund. But such focused largecap funds will have higher volatility in performance, but shall have better chance of outperforming its benchmark in the long run.

Higher flows in top performing stocks: As seen in the last 2 years, only few stocks in the index have contributed majority of the returns. As active fund managers buy more and more of these stocks or stay away from these stocks and simultaneously more money being pumped into index funds (EPFO investing in index funds) that keep increasing their weights in the index, it will become difficult for an active fund manager to beat the index. It is a vicious cycle.

Should you not invest in largecap Funds now?

For many years largecap funds were meant to be core part of ones portfolio, not any more. With shrinking alpha one may be at risk if he invests majority of his money in these funds. It is better is you replace them with good multicap funds. Multicap funds are flexible and hopefully will generate better returns with slightly higher risk.

A small percentage of the portfolio can still be invested in largecaps via Index Funds. Many people argue that active largecap funds may still be able to beat index over next couple of years if not over next 10 years. But then most of us are investing for long term goals that are beyond 10 years, then why take that risk? Yes, some good fund managers can still outperform index, and for those who believe in them can continue to invest in active largecap funds, but should at least have 50% of the exposure to largecaps through index funds. Just in case their view goes wrong they are still safe. While I don’t see active largecap funds vanishing any time soon, but it is good to protect your portfolio from underperforming the index by having small exposure in index funds.

Passive investing is like god, if you believe in him and even if he happens to exist or not, you are fine. But if you don’t believe in him and he happens to exist then you are at a loss.

Happy Investing!

One thought on “Is time ripe to replace your Largecap Fund with an Index Fund?

  1. There are four risks in a share – growth risk, margin risk, valuation risk and governance risk. And of course, the risk/ fear of missing out. One of my ex-bosses used to day passive funds and active fund managers play on the latter. Which is not too bad for most investors given their philosophy is like that only and passive funds at least have low cost. But 100pc passive funds at market level will massively increase the governance risk. While passive is not a fad, but near its peak in developed markets – and active funds (with good processes) will always have their day under the sun. In india, consol in active space is inevitable.

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