Classification rule changes lead to below-par performance by large-caps

The S&P Dow Jones Indices, published a report in April 2023. According to the report, 88% of actively managed funds underperformed the S&P BSE 100 in 2022.

The question arises what was the reason of this underperformance? Before we answer this question, let’s first understand what large-cap mutual funds are. The Securities and Exchange Board of India (SEBI) states that large-cap funds are mutual fund schemes that invest at least 80% of their assets in the stocks of large-cap companies. Large-cap stocks are stocks of those corporates whose market capitalisation is that of top 100 companies. For instance, companies such as Reliance Industries, Infosys, ICICI Bank, HDFC Bank, and Ultratech Cement are a few examples of large-cap stocks.

Risk tolerance

Risk tolerance is one of the first things that investors should consider before investing in large-cap funds. Large-cap funds are an option for those investors who have a moderate risk tolerance appetite. Large-cap funds can be the best option for those who are investing in the mutual fund market for the first time in their life.

Now, we return to the question why have large cap funds underperformed benchmark indices. Market experts have pointed out various reasons for underperformance of these schemes. Before 2017, there were very few classification guidelines established by the SEBI.

AMC investment

AMCs were given permission by SEBI to invest in companies across a range of market capitalisation. However, in 2017, SEBI made it clear that large-cap funds should invest at least 80% of their assets in large-cap equities. This has reduced the likelihood that actively managed large-cap mutual funds will outperform the index. Moreover, active mutual funds usually have a higher expense ratio because of fund manager’s active involvement in the scheme.

The average expense ratio of a large-cap mutual fund usually ranges between 0.5%-1.50%.

Despite charging a higher expense ratio, large-cap funds have failed to deliver decent returns and continue to underperform their respective underlying index.

So, experts believe that a major reason behind under performance of large cap funds has been the volatility in the stock market.

Only a few sectors delivered double-digit returns. Few other sectors also took heavy beatings. Even selecting the right sector wasn’t enough, as only a few companies could deliver returns. According to a financial expert, one year is too short to gauge a large-cap mutual fund’s performance. In 2021, active funds saw huge outperformance. So, investors should treat large cap funds as a test match and focus on the long term.

According to Shweta Jain, CFP and founder of Investography, large-cap funds will continue to find it difficult to outperform indices as these have high costs to bear. Funds would need to take additional risks or concentrated bets to beat benchmark indices. Investors unwilling to take these risks should stick to index funds.

Money9 suggests
Investors should look for a large-cap fund that has consistently outperformed its peers and beat its benchmark index. Your research will be halfway complete if you are able to find a fund that does that and has a reasonably long and reliable track record. You should look for a fund with a reduced expense ratio that offers you more significant returns.