Mutual funds’ large-cap schemes are generally marketed as a source of stable and steady money-making over time. But according to recent information available with the Association of Mutual Funds in India, large-cap schemes tend to underperform relative to their benchmarks over a ten-year period. The implications of such findings are important for active management investors.
The Alpha Reality Check
A study of large-cap mutual funds indicates that the creation of alpha, i.e., achieving returns in excess of the benchmark, is much harder than expected. In India, there are 34 large-cap mutual funds operating actively, out of which only 23 have a history of at least 10 years. However, only 3 out of these 23 schemes outperformed their benchmarks in case of regular investments.
It amounts to an impressive 13% success rate, implying that most actively managed large-cap mutual funds cannot beat their benchmarks.
Even more impressive is the comparative performance in terms of returns. In the past ten years, large-cap funds returned 11.59% on average, whereas their respective benchmarks—the Nifty 100 TRI and BSE 100 TRI indices—generated superior returns of 12.80%.
Plainly put, investors would have been better off by simply indexing the benchmark rather than entrusting their money to fund managers.
Large-Cap Funds’ Failure to Outperform Explained
It cannot be emphasized enough that the underperformance of large-cap funds is not coincidental but structural. The large-cap space is highly analyzed, followed by numerous institutions, and is subject to efficient global information flows. Therefore, there is not much room left for fund managers to discover undervalued assets.
As it is noted, in this mature sector, stock selection is a minor factor in generating returns, which heavily depends on tactical asset allocation and timing strategies.
Unlike mid-cap or small-cap segments, where inefficient pricing provides room for alpha generation, large-cap management is a zero-sum game, where success is rare and fleeting.
Expense Ratios: The Unseen Performance Sapper
Among all factors affecting performance, expenses rank high. Of the few funds that were able to produce alpha, their expense ratios varied from 1.4% to 1.6%, lower than the overall industry expense ratio of 1.96%.
Higher expenses reduce profitability, and it becomes increasingly clear with a comparison of regular plans versus direct plans.
With the latter choice, the number of outperforming funds increased substantially, from 3 to 11. Average returns of funds in direct plans reached 12.74%, with an expense ratio of approximately 0.88%.
It clearly indicates that the cost of a scheme can determine its success in the long term.
Direct Plan or Regular?
The substantial difference in performance of these two types of plans provides another critical piece of advice: distribution expenses affect performance.
With regular plans, the commissions of intermediaries add up to expense ratios, reducing investors’ returns. With direct plans, all distribution expenses are cut off, giving investors more of their profits.
Even a small 1% reduction in expenses per year matters significantly to investors over the course of several years.
Who Are the Outperformers?
The narrow pool of top-performing funds comprises products by prominent fund houses like Nippon India Mutual Fund, ICICI Prudential Mutual Fund, and HDFC Mutual Fund.
Common features among these funds include:
1. Low expense ratios
2. Sound investment philosophy
3. Portfolio discipline
But even within this category, generating alpha over long periods proves challenging.
Should Investors Ignore Large-Cap Funds?
While these funds struggle to generate superior returns, they remain indispensable for an investor’s portfolio.
According to experts, they make great allocations because they provide the following:
Stability amidst market turbulence
Investment in fundamentally solid businesses
Relatively lower risks as compared to mid- and small-cap funds
Instead of aiming for high returns, large-cap funds focus more on wealth accumulation and capital protection.
Passive Management Makes a Comeback
Apart from the poor performance of actively managed large-cap funds, the recent popularity of passive management can be attributed to this trend.
Index funds and ETFs, which merely track benchmark indices, present:
Low costs
Clear-cut methodologies
Benchmarked returns
With benchmarks already beating the majority of active funds, passive investing makes more sense for thrifty investors.
Takeaways for Investors
There are certain takeaways from the AMFI data that are very important:
Low alpha among large-cap funds—Only 13% were above the index in 10 years.
Expenses play a vital role—the lower the expense ratio, the better the results.
Direct plans work better—the absence of commission makes them more profitable.
Large-cap equity is about stability—not outperformance.
Index funds provide a good investment avenue—inefficient markets.
Conclusion
The idea that active management produces better results than passive investing is increasingly being refuted—particularly in the case of large-cap mutual funds. Although such funds are vital for building a stable portfolio, investors have to accept the reality of low alpha.
When beating the benchmark becomes a rarity, the better way may not necessarily be looking for the best fund to invest in but ensuring cost-effectiveness and self-discipline.
This lesson can serve investors well in their pursuit of consistent and rewarding returns from large-cap mutual funds.
