Large Cap Funds: Should You Invest In Them Now?
Large-cap dedicated equity funds that form a major part of equity AUM in India are witnessing contraction in their performance of late. DSIJ delves on the reasons for such performance and what should be your next move as an investor.
Even the slowest of swimmer will swim fast, if he is swimming with the current. The reason: the current is on his side! The same is true for the Indian mutual fund industry. The benign equity market and large-scale investor awareness campaigns by industry body has helped the industry to grow its asset under management (AUM) hugely, and this is especially true for the equity-dedicated funds. The FY2017-18 remained a dream year for most of the asset management companies (AMCs) as some of the AMCs saw their AUMs doubling in FY18. However, and the industry at the aggregate level saw its AUM swelling by 26 per cent on a yearly basis. This was on top of 35.2 per cent rise witnessed in FY17 over FY16.
Rise of Equity Funds and Large cap funds
One of the factors that have really helped such increase in overall AUMs is the rise in inflows of funds in equity-dedicated mutual funds, including tax saving funds such as ELSS. If we analyze only the net inflows into equity funds, it has more than doubled in FY18 to reach Rs 1.71 lakh crore. Such a huge inflow this year and the year before has helped equitydedicated mutual fund schemes to increase their pie in the overall mutual fund industry, which historically has been dominated by the debt mutual fund schemes. The equitydedicated mutual funds that formed merely a quarter of the total AUM of the entire mutual fund industry at the end of FY13 now form 35 per cent of the total AUM.
Even among the equity schemes, most of the inflows have been to large-cap dedicated funds. Between FY13-FY18, (see table below) the AUMs of large-cap funds has witnessed a scorching pace of growth at 39% annually.
The AUMs of large-cap dedicated funds now (May 7, 2018) form almost 37% of the entire equity-oriented funds, including tax saving schemes, but excluding hybrid funds.
The bitter Medicine
The market regulator SEBI, working on the theory that good time is the best time for a bitter medicine, issued couple of directives to the mutual fund industry that will have a farreaching consequence in shaping up the entire mutual fund industry and its performance.
First one is related to suitable benchmarking of the mutual fund schemes. According to the circular issued by SEBI, the performance of the mutual fund scheme is required to be benchmarked against the total return variant of the selected index, also known as the total return index (TRI). The current practice by most of the fund houses, baring couple of fund houses, is to use price return variant of the index known as PRI to benchmark their fund's performance. The difference between total return variant and price return variant is the dividend distributed by companies. TRI assumes that cash dividends are reinvested into index. The performance of a PRI, however, captures only the capital gain or loss and not the dividend received from the shares, whereas a TRI includes both. This is a reason why returns shown by TRI are more than PRI and the difference is mostly the dividend component and its growth over the years. This use of TRI to benchmark will help investors to compare the fund's performance in a fair manner.
Small Move, Large Implication
This little shift in the benchmarking will make a huge impact in the performance of the funds. To understand it better and how it is going to impact the larger share of AUMs which are dedicated to large-cap funds, we studied the monthly returns of all the large-cap funds since 2009. We took the aggregate return of all the funds of that month and compared it with the returns generated by Nifty 50 during the same period. The reason we took Nifty 50 as the benchmark index is because most of the large-cap funds use Nifty as their benchmarks.
A total of 110 monthly returns were analyzed, and we found that on an average, the large-cap funds performed better than Nifty 50 (considering PRI as its benchmark) in majority of months.
However, the picture changed when we compared the aggregate returns of the funds with Nifty's total return. While considering PRI, 53 per cent of the time on monthly basis, the aggregate return of the funds has beaten index returns. In case we took TRI, only 45 per cent of time the funds were able to beat the index. This shows that funds underperformed most of the times when we took Nifty TRI as the benchmark. The average underperformance of the large-cap funds on monthly basis is 0.05 per cent, which looks miniscule, however, it will be substantial if we take a long-term investment horizon.
The long-term repercussion
The investment in mutual fund is long term in nature and, hence, to make our study closer to the practical situation, we extended our study of returns for one year, three year and five years. We took the rolling returns for one year, three years and five years for all the funds that are in existence since 2009. Some of you will argue that this will have survivorship bias. For the uninitiated, this means viewing the performance of the existing funds in the market as representative and overlooking those funds that did not survive long to make it to the list. This may give a biased view. Nevertheless, one of the study done by Morningstar shows that among the large-cap funds in India, survivorship rate is 89.6% for 10-year trailing period, which is relatively high. Therefore, the study does not suffer from survivorship bias.
The study of yearly returns of large cap funds throws an interesting picture. The outperformance of the funds has declined over the years. A one-year return comparison shows that out of 100 instances of study, the average returns of the funds was greater than Nifty (TRI) 45 times, while 55 times it is less than Nifty TRI returns. The interesting part is that most of the outperformance of the funds was till the year 2010. Post that, the outperformance sharply deteriorates. For example, out of the 12 instances of the year ending in 2010, the average return of funds was greater than the Nifty TRI eleven times. For all the yearly study ending in the year 2018, the large-cap funds have hugely underperformed Nifty TRI.
Rise in efficiency of Indian equity market
One of the reasons for such underperformance by the largecap funds after 2011 is due to the increase in the efficiency of the capital market in India, and especially among the large-cap stocks. This is clearly illustrated by the lower volatility of returns across all the time horizons (1-year, 3-year, 5-year and 10-year), which has come down by as much as 2/3 as compared to what was observed in 1990s. Besides, the correlation between the EPS growth and the stock prices has increased in the last ten years, with the use of price sensitive information at any moment and hence there is little chance of discrepancy in pricing of securities.
Moreover, as all the research firms have access to the same information at the same time, the pricing error has further reduced. Earlier, exclusive information about companies were used by active investors to outperform the market. Apart from the availability of information, what is also adding efficiency to the Indian equity market, and especially to large-cap stocks (representing top 100 stocks by market cap), is higher coverage by analysts, which further limits the scope of pricing error. According to Bloomberg estimates, at least 40 brokerage firms on an average track a company in the Nifty 50 index. Comparatively, 16 brokerages track companies in the Nifty Mid-cap 100 index and just nine track those in the Nifty Small-cap 100 index.
In this scenario, it will become even more difficult for the large-cap funds to outperform the index, at least in the shorter duration.
Nonetheless, for the longer time horizon, this may be possible. Data for the three-year and five-year periods show that large-cap funds on an average were able to beat the Nifty TRI most of the times, albeit with a slim margin. Nevertheless, the trend continues but, of late, the outperformance has been declining. One of the reasons why fund outperformed its benchmark index in the longer time horizon is because, many a time, the fund manager takes a contrarian view and bets against the market, which pays off in the long term. However, it does not pay always to be contrarian.
The discussion above is on an aggregate basis and we compared performance against Nifty. It is like painting the entire picture with the same brush. To understand the return patterns clearly, we dig the surface little bit more and tried to understand if the aggregate is masking some other aspect of returns.
Instead of comparing the performance of funds against the Nifty, we evaluated the funds' monthly performance against the monthly performance of their benchmarks. There are mostly five benchmarks used by large-cap funds.
Although majority of funds have been able to beat their benchmarks, there are couple of catches in this outperformance.
First, we have taken price return index (PRI) variant of the index and hence such outperformance is visible. Second, the funds following S&P BSE 200 and S&P BSE 100 as their benchmarks have performed better than their index. Some of the companies in these indices are not widely tracked, hence this gives the fund manager the opportunity to generate alpha for the funds managed by them.
Nevertheless, the interesting part is the distribution of this outperformance. The figure shows that most of the outperformance lies in the range of negative 0.07% to positive 0.12%. So, if we take the dividend yield as the difference between TRI and PRI index, which is near one per cent, you will find that most of the outperformance will disappear.
Therefore, although the performance of the large-cap funds might look good, but when adjusted for the TRI, it vanishes.
Categorisation and rationalisation of schemes
The other important circular issued by SEBI in the month of October 2017 was regarding the categorisation and rationalisation of the mutual fund schemes. The circular also provided clear definitions for large-cap, mid-cap and small-cap stocks. It also laid out what portion of these stocks should be held by any category of schemes. For example, a large-cap fund should hold 80 per cent of its assets in large-cap stocks.
Similarly, a mid-cap fund should hold 65 per cent of its assets in mid-cap stocks.
This directive has further put a restriction on large-cap funds to create better returns and beat the benchmark. Earlier, it was not uncommon to find more than 30 per cent of the assets of large-cap funds deployed in mid-cap stocks. This helped the funds to create superior returns, but it also entailed a higher risk. It defeated the very purpose for which an investor has invested in large cap stocks. As most of the investors seek stability in returns while investing in large cap funds.
The way ahead and what you should do
Large-cap funds are among the most-owned funds in India and hold one of the largest assets under their belt. The recent development clearly shows that, going forward, creating superior returns is going to be tough for large-cap funds. Nevertheless, large-cap fund managers' skills will also now be tested as to how they deploy 20 per cent of their corpus to beat the benchmark returns. If you are new to mutual fund investment and want to take exposure to mutual funds, you can consider large-cap funds as they may provide you stable returns. Nevertheless, if you are a seasoned investor and want to allocate part of your portfolio to large-cap funds, the exchange traded funds or index funds that track large-cap index such as Nifty, are better alternatives to large-cap funds as they give exposure to large-cap stocks at lower cost..