Largecap mutual funds seen struggling for downside risk-adjusted returns

Midcap and smallcap funds have done better in recent times

Mutual fund (MF) schemes focused on India’s largest listed companies have struggled to generate significant returns relative to the amount of downside risk they face, going by a key measure — the Sortino ratio.

 

The Sortino ratio calculates the amount of return generated for every unit of downside risk taken by a scheme. A ratio below 1 suggests that the excess return of the scheme is smaller than the downside risk for the scheme. It is a variation of the Sharpe ratio and is more suitable for investors desiring to avoid downside risks.

 

No largecap scheme recorded a Sortino ratio of more than 1 over a three-year period, the standard period for which the ratio is calculated by Value Research, shows a Business Standard analysis of actively managed direct equity schemes across categories. The data is as of July 7 — the day before US President Donald Trump announced hostilities with Iran again, triggering a fresh round of volatility — and gains significance as an indicator of ability to generate returns amid elevated market risk.

 

Only 21.7 per cent of flexicap funds have managed a Sortino ratio greater than 1. While flexicap funds have the ability to invest across different company sizes, much of the allocations are made to largecap names, according to Value Research.

 

On the other hand, funds invested entirely in midcap and smallcap companies have done relatively better. The majority of schemes in both categories have a Sortino ratio of more than 1. 

 

The Sortino ratio depends on the difference between fund returns and the risk-free rate, noted Bipin Ramachandran, senior mutual fund analyst at PrimeInvestor. The risk-free rate has been on the higher side relative to the decline seen during the pandemic. The higher Sortino ratio observed in the midcap category is likely driven by its robust returns over the preceding three-year period.

 

“In the last three years, midcap has given the highest returns,” Ramachandran said.

 

The midcap category as a whole, not just active schemes, has generated 19.09 per cent compound annual returns over a three-year period. This is higher than smallcap schemes (17.95 per cent), flexicap schemes (13.27 per cent), and largecap schemes (11.49 per cent).

 

Much of this has flowed from index performance, which has been more of a tailwind for some categories than others. The BSE LargeCap index has given compound annual returns of 9.3 per cent over the previous three years. It was 18.2 per cent for the BSE MidCap index and 19.1 per cent for the BSE SmallCap index.

 

There is wide divergence within the category. The highest Sortino ratio for the flexicap category was 1.59, while the lowest was -0.2. The largecap category Sortino ratio ranged between 0.32 and 0.86. It was between 0.51 and 1.4 for the midcap space. In smallcap schemes, the range was between 0.65 and 1.66.

 

Limited growth in earnings and poor outlook for many largecap companies have resulted in stock underperformance, pointed out Kartik Jhaveri, director, Transcend Capital. Meanwhile, many midcap and smallcap companies have done better on both earnings and stock performance. This will also reflect in the Sortino ratio for these categories. Ratios could improve across categories when the cycle turns, according to Jhaveri.

 

“Maintain your allocations... sooner or later things should turn around,” he said.