Tilt portfolio towards large-caps for smoother path amid market volatility

These funds have contained downside risk better than mid- and small-cap categories in past downturns

With the United States and other major central banks rolling back liquidity faster and planning to hike interest rates, and foreign institutional investors (FIIs) pulling money out of Indian equities over the past few months, the market is expected to be volatile. Experts suggest having a higher allocation to large-cap funds in this environment.

Tactical and strategic reasons

Mid- and small-cap stocks ran up more than large caps in 2021. “In the current scenario, where overall equity valuations are frothy, mid- and small-cap stocks are more richly valued than large caps,” says Kaustubh Belapurkar, director-manager research, Morningstar Investment Adviser India. While the Nifty 50 index is trading at a 12-month trailing price to earnings (P/E) ratio of 24.5, the Nifty Midcap 150 is at 30.9, and the Nifty Smallcap 250 is at 31.4. Investors should move some money out of mid- and small-cap funds and into large-cap funds.

Investors’ long-term asset allocation should also be skewed towards large-cap funds. “They contain volatility much better, as one saw most clearly during the crash of 2008,” says Ankur Kapur, managing partner, Plutus Capital, a Sebi-registered investment advisory firm. Large-cap stocks belong to well-established businesses. While their earnings growth rate may be slower than that of mid- and small caps, they display steady-state growth due to which their stock prices decline less during market downturns and recover faster afterwards.

Newcomers must stick to passive

One reason for selecting passive funds is that actively managed large-cap funds have struggled to beat their benchmarks, as successive SPIVA (S&P Indices versus Active) reports have shown. “The June 2021 report shows 66 per cent of large-cap funds underperformed the S&P BSE 100 index over 10 years,” says Avinash Luthria, a Sebi-registered investment advisor and founder, Fiduciaries.

New investors, who are unable to decide which active fund to buy, should begin by investing in a passive fund.

Different investment styles—growth, value, and growth at a reasonable price (GARP)—work in different market conditions. “A new investor may pick up a fund based on recent performance. After he has invested, this style of investing may stop working for some time. The novice investor will not understand this. Instead of staying invested for an entire market cycle, he will switch out and invest in another fund performing well currently,” says Belapurkar. Such investors are more likely to stick to passive funds where they will have the satisfaction of getting market-equivalent returns.

According to Luthria, most retail investors should opt for a Nifty 50 index fund rather than an exchange-traded fund (ETF). “Go for the direct plan of a Nifty 50 index fund having an expense ratio of up to 0.2 per cent and belonging to one of the bigger fund houses,” he says.

Evolved investors may opt for a Nifty 50 ETF purchased through a low-cost broker. Besides a low expense ratio, they should look for one having considerable trading volume (ETFs with low liquidity have issues like mismatch between net asset value and market price).

Active option for alpha

An investor who has a financial advisor may consider an active fund, provided he is prepared for the risk that only a small percentage of these funds may outperform the benchmark over the long term.

Those selecting an active fund themselves must ensure the manager follows a consistent fund management style. Ascertain this by looking up the fund’s historical style boxes. “Check the fund’s long-term rolling returns. This can be done by looking up five-year returns, rolled monthly, over 10 years,” says Belapurkar.

Having selected an actively managed fund, stay invested for at least seven years so that you earn returns across market cycles. Also, diversify across fund-management styles instead of loading up on one that has done well recently. Finally, avoid an active fund with a good track record if the fund manager who generated those returns has quit the fund house.