Passive funds make good bets as large-cap schemes strain to beat the index

New launches within the passive-fund domain have made it possible to build a complete portfolio out of such products

The data in the recently released S&P Indices Versus Active (SPIVA) India scorecard for mid-2019 shows, as it has been indicating for some time now, that large-cap funds are struggling to beat the index. The data on the mid- and small-cap side is not as unequivocal. Over a five-year horizon, only about 27 per cent of funds were beaten by the benchmark, though over the 10-year horizon, the number rises to about 49 per cent, indicating that the investor would have a 50-50 chance of beating the benchmark with an active fund manager. Reading the writing on the wall, fund houses have been bolstering their suite of passive products so that it has now become possible to construct an entire portfolio out of such products.

Underperformance in large-cap segment: In the large-cap segment, India appears to be following the global trend. This part of the market is extensively researched by institutions. The penetration of social media also means that information about stock-related developments gets disseminated very fast. Hence, information asymmetry has almost disappeared in this segment, making it difficult for fund managers to outperform.  

A few recent developments have also made large-cap fund managers’ job more difficult. In October 2017, the Securities and Exchange Board of India (Sebi) re-categorised mutual funds, making it mandatory for fund managers to take at least 80 per cent exposure to large-cap stocks, defined as the top 100 stocks by market cap. Experts say that if the majority of large-cap fund managers failed to beat the benchmark in the past when they had greater leeway, their chances of doing so now have shrunk even further.  

Over the past 12-18 months, the Indian market has been heavily polarised. The Nifty 50 rally has been driven by just six-seven stocks, making it difficult for active fund managers, who hold more diversified portfolios, to beat their benchmarks.

Relatively high expense ratios of active funds, especially the regular variety, have also contributed to underperformance.   

DSP Investment Managers did some analyses on outperformance by large-cap funds between 2000-2009, and 2010-2019. “We found that the alpha of five-year daily rolling returns has reduced from about 4.9 per cent during the earlier period to around 0.1 per cent in the latter period,” says Anil Ghelani, head of passive investments and products, DSP Investment Managers.  

In the mid- and small-cap segments, most experts still believe that fund managers have scope to outperform, as the investment universe is wider and less well-researched. Explaining the anomaly between five-year (26.98 per cent) and the 10-year (48.84 per cent) data for this category, Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors says: “Remember that this is trailing data, which gets influenced by specific market conditions. In this segment, we need to see evidence of underperformance on a more sustained basis before advising investors to shift to passive funds.”

Start passive allocation: Based on current evidence, investors need to begin adding low-cost passive products (ETFs or mutual funds) to their core portfolios. “In the large-cap segment, at least half of the exposure should be through passive funds,” says Dhawan.

Now, let us turn to some of the novel products that have been launched by fund houses.

Aashish P Somaiyaa MD & CEO, Motilal Oswal AMC

Nifty 500 index fund: With this one fund, an investor gets exposure to all sectors and market caps, or virtually the entire market. Unlike the Nifty 50 index, which is dominated by the banking and financial sector (35-40 per cent weight), this index reflects the Indian economy better. “It is ideal for the novice investor who does not know which market cap or fund manager to select,” says Aashish P Somaiyaa, managing director and chief executive officer, Motilal Oswal Asset Management Company, which launched this fund in September 2019. In the absence of such a fund, the investor would have to use a number of passive products—Nifty 50, Nifty Next 50, mid-cap index fund and a small-cap index fund—to build a portfolio encompassing the entire market.

One downside of the product is that it reduces flexibility. “Many more evolved investors take tactical calls. They tilt their portfolios towards mid- and small-cap funds when large-caps become overvalued, and vice versa. Such active rebalancing of the portfolio will not be possible with this fund,” says Dhawan.

Midcap 150 and Smallcap 250: Until recently, diehard passive investors who didn’t want to take fund manager risk were hamstrung by the lack of passive options in the mid- and small-cap space. Now, Motilal Oswal AMC has made it possible with the launch of these two index funds. Since stocks beyond the top 150 have low liquidity, some experts fear that tracking error could be high in these funds, and hence needs watching. Somaiyaa says that this is not an issue currently when the AUM of these funds is not very large.  

Nifty Private Bank ETF: ICICI Prudential AMC and Tata AMC launched this product in August 2019. The Nifty Bank index also includes PSU banks which many investors did not want exposure to. The rationale for this product also comes from the fact that this index has beaten both the Nifty Bank index and the Nifty 50 index over the long term. While this index has given a return of 17.49 per cent, the Nifty Bank Index has given 13.37 per cent and the Nifty 50 has given 9.61 per cent (source: mutualfundindia.com) over the past 10 years. Investors need to be aware that the Nifty 50 is already weighted heavily in favour of the banking and financial sector. By investing in this sectoral fund, the investor risks overexposure to this sector. 

Large-cap funds are struggling
		Percentage of funds outperformed by index
Fund category	Index	1-year	3-year	5-year	10-year
Large-cap	S&P BSE 100	76.67	82.93	65.71	61.34
ELSS	S&P BSE 200	80.95	83.33	51.35	45.71
Mid/small-cap	S&P BSE 400 MidSmallcap	18.92	47.83	26.98	48.84
Source: SPIVA India Scorecard for mid-2019. Data as on June 28, 2019