Large cap equity funds actively managed by renowned fund managers have been highly criticised for delivering sub optimal returns in the last two to three years. While some of the biggest large cap equity funds delivered returns in the range of 11-13% annualised in the last three years, the BSE Sensex was up around 15% annualised for the same period.
The ability of active large cap funds to beat the index returns is reducing. Some may still be doing it over a long period of say 5 or 7 years but overall the margin by which they outperform the index is shrinking.
What this means is that if you had simply invested in the Sensex or some derivative of it like an exchange traded fund based on the Sensex you could have earned much more than relying on fund managers to pick stocks for your mutual fund portfolio. However, if we stretch back say 5 or 10 years, then it can be seen that active large cap funds did better or at least as good as their passive counter parts (exchange traded funds linked to large cap indices like Sensex and Nifty). What we do know for sure is that on the whole, the ability of active large cap funds to beat the index returns is reducing. Some may still be doing it over a long period of say 5 or 7 years but overall the margin by which they outperform the index is shrinking.
Yet there is a school of thought that believes that this underperformance from active large cap funds is restricted to the recent 2-3 years and things will get better going forward.
Why are they underperforming?
To understand whether this is a sustainable trend we need to figure out why it is happening. The first thing to keep in mind is that the size of large cap funds has increased manifold in say the last ten years. And this has happened at a pace faster than the creation of large cap stocks. What this means is that a lot more money is being invested into the same set of stocks. As this has happened, the information available publicly about these stocks has become a lot more efficient. As a result, the ability to beat the market – which is what makes a fund manager stand out – by picking these stocks has reduced.
Secondly, as ETF investing becomes more and more popular among large sized institutional investors, the largest holdings or stocks in an index are bought the most and those are the ones that keep gaining in price. While they are heavyweights in the index, it may not be the case in an actively managed fund, which then loses out in return as compared to the index itself. This is kind of a vicious circle. If you believe that index-based investing or ETFs are going to gain momentum in the future then it will be hard to break this cycle.
Thirdly, it’s the difference in expense structure that makes ETFs lose out as compared to large cap funds. Some of the largest actively managed large cap funds carry an annual expense ratio of 2-2.5%. The returns you make on the fund are net of these expenses. Now say that you had to pay only 0.5% expense a year – immediately your returns look better by 2% annually. This is where ETFs fit in, ETF expense ratios are rock bottom at 0.05%-0.1% for most of the large sized ETFs.
I would say if you are a first-time investor, your mutual fund experience can only be enhanced by picking a large cap ETF rather than an active fund. However, investing in an ETF requires you to open a demat account. If you don’t want to do that, you can pick an index fund which is similar to an ETF but does not require a demat account, the expense ratio may be slightly higher than an ETF. If you look close enough, you can perhaps find a handful with expense ratios as low as ETFS too.
After putting my thoughts down on this one, I am convinced that I need to move my large cap fund holdings to an ETF soon!