Why passive large-cap funds are now ruling the charts

Don’t know the difference between active mutual funds and their passive counterparts? Read on!

Why passive large-cap funds are now ruling the charts

Unlike with active funds, fund managers have no role to play in passive funds. The portfolio of such funds simply mimics an underlying index (such as Sensex or Nifty50), so there’s no need for stock-picking by fund managers. It’s a simple cloning of the index portfolio. 

The returns obviously are very close to the calculated index returns, not counting some fees and tracking errors.

Passive mutual funds (index funds) and ETFs have been very successful in developed markets such as the US. In India, on the other hand, they haven’t been as popular. The reason is that over the years, a good number of actively managed funds have been able to deliver better-than-index returns. But things might change soon, as some recent developments shake up the mutual fund landscape.

The first of these involves the Securities and Exchange Board of India (SEBI) asking all asset management companies (AMCs) to reclassify their schemes in accordance with the new fund categories proposed in 2017-18. 

This categorisation and rationalisation order has led to the tightening of category definitions. For example, a large-cap fund now has to invest at least 80% of its corpus in the 100 largest companies. The remaining 20% is free to be invested in other stocks.

This restricts what fund managers can do when picking stocks. Traditionally, active equity funds in India outperformed their benchmarks by taking flexible market-cap calls. So a large-cap fund often beat the benchmark by bulking up returns by taking aggressive small- and mid-cap bets.

But now, after SEBI’s new rules, fund managers will be forced to stick closer to their defined market cap range. In a way, this translates to a reduction in the alpha generated through market cap drift. Chances are this may narrow the outperformance of active funds with respect to their benchmarks.

Consequently, fund managers’ skills will now be tested as to how they manage the remaining 20% of the corpus to generate alpha by investing in mid- and small-sized companies. And of course, by taking tactical stock-based weight calls on the remaining 80% of the large-cap portfolio they are mandated to hold. The second big change was SEBI’s order that all equity schemes must benchmark their performances against a total return index (TRI).

Why was this order passed?

Most active funds were not benchmarked to total return indices. A TRI shows higher returns than the normal index because of the added dividends. So the outperformance claimed by the mutual fund schemes (over their chosen non-TRI benchmark indices) was not correct because the returns shown by funds had dividends included, whereas the benchmarks were based only on price. So now the funds will have higher benchmarks (TRI) to be judged against.

So what does all this mean for the investor?

With higher hurdle rates to beat (TRI indices) and restrictions in taking investment calls (category-wise limit on the stock universe), fund managers may find it difficult to generate alpha against their benchmarks. If we take a look at the data, it can be found that over the years, the excess return generated by active managers is reducing.

So should we just write off the active funds now?

No. And that’s because each year there still are several active funds that outperform the index. So fund managers will continue to outperform. As a trend, this outperformance will reduce going forward. But it still does not mean good fund managers with good stock-picking and allocation skills cannot deliver better returns.

To be fair to active funds, we are yet to see how they will perform (when compared to passive funds) in the future when they face greater hurdles. So in spite of index funds seemingly a good choice now, we must accept that carefully chosen active funds can still be worthy bets.

A good fund manager, by opting for large positions in a select few high-conviction bets, and taking contrarian bets to contain the downside better, can still deliver index-beating returns.

In future, a closer monitoring of fund performance is required, and if active funds continue to lag behind the benchmark indices for a few more years, the case for gradually shifting to index funds (or ETFs) will become very strong. 

Of course, if you wish to make that transition right away, it may not be such a bad choice.

Dev Ashish is a SEBI-registered Investment Advisor and founder of StableInvestor.com. He advises people to better manage their finances through investment & financial planning.


Related Article

Premium Articles