How Finology selects Best Large Cap Funds?

Large Cap Mutual Funds are equity mutual funds that invest a major proportion of their total assets in companies with large market capitalisation. These funds are required to invest atleast 80% of their assets under management (AUM) in large cap companies.

Large-cap funds provide a decent opportunity to grow wealth. Being relatively more stable than other assets, these funds can be good for long-term wealth creation.

Stability becomes more important than anything when you are investing for your goals. Even while picking stocks for Finology 30, we choose stocks that you can rely on for the long-term.

Similarly, the objective while selecting large cap mutual funds is to build the base of your portfolio. If all you want is to generate alpha or beat the markets by a huge margin, you should look beyond large cap funds.

To select the best large-cap funds, we followed a multi-layered screening method with more focus on reducing risk. The first question was whether to go with active funds or index funds.

Active Large-Cap Funds vs Index Funds

Index funds track the index, whereas active funds try to outperform the index. Our research reveals that over a 10-year horizon, actively managed large-cap funds outperformed index funds by a mere 1.37% CAGR.

However, SEBI reclassified large, mid, and small-cap funds in 2017. Prior to this reclassification, active large-cap funds often invested in mid-cap stocks, allowing them to generate higher returns. Post-2017, active large-cap funds are required to invest at least 80% in large-cap stocks, limiting their previous flexibility.

In the last 5 and 3 years, the outperformance of active large-cap funds over index funds has reduced to 0.77% and 0.17%, respectively. Evidently, the alpha generated by active large-cap funds has been reducing over time following the SEBI reclassification.

While active large-cap funds can deviate from their conservative approach and invest in mid or small-cap stocks after meeting the 80% large-cap requirement, this marginal alpha generated may be due to the additional risks associated with such investments. And such risk in the large-cap category is not viable.

Most active large-cap mutual funds have a portfolio of around 50-75 stocks. Having a portfolio of 50-75 stocks from a universe of 100 large-cap stocks makes it difficult for any fund manager to create significant alpha, as the majority of their portfolio strongly overlaps with the benchmark it's tracking.

At Finology, the approach has been to align with investors' thought processes when investing in a particular category. Most investors in the large-cap fund category prefer capital safety and lower costs over alpha generation. Getting 0.5%-1% extra returns for an additional amount of risk is not worth it.

Considering our focus on reducing risk, we prefer index funds over active funds in the large-cap category.

There are two routes to investing in index funds: either an ETF or an index mutual fund.

ETFs vs Index Mutual Funds

Exchange Traded Funds (ETFs), like index mutual funds, track a specific index or instrument. The only difference is that ETFs are traded in the exchanges just like stocks, and their prices fluctuate throughout the day.

Although ETFs have lower expense ratio compared to index mutual funds, we preferred to go with index mutual funds due to the following reasons:

• Accessibility: Index funds are not bought on exchanges and do not require additional efforts to have a demat account. An individual not having a demat account can also invest.
• Costs: Although ETF expense ratios look cheaper, they carry brokerage costs and transaction charges, GST etc, since they are traded on exchanges.
• Liquidity: Although ETFs are traded on exchanges, they may have liquidity risks. This is because liquidity in ETFs depends on average daily trading volumes. If average daily trading volumes are low, redeeming ETFs becomes difficult. Liquidity is not an issue with index funds because you can redeem your units with the AMC anytime.

The choice was clear – Index Mutual Fund. But again, what kind of index mutual fund?

Market Cap Weighted Index Funds vs Equal Weight Index Funds

Market Cap Weighted Index Funds give more weight to larger companies, while Equal Weight Index Funds give the same weight to all companies, regardless of size.

Since all index funds have similar stock holdings, they cannot be compared based on metrics like beta, standard deviation, portfolio mix, sector allocation, etc.

However, due to more rebalancing costs, equal-weight funds tend to have a higher expense ratio compared to other index funds despite same holdings.

Therefore, we rejected equal-weighted index Funds.

Next choice was between funds tracking Nifty vs funds tracking Sensex.

Nifty vs Sensex Index Funds

Large Cap Index Funds track either of the two indices - Nifty or Sensex.

One important choice to make here is funds tracking; which of these two indices is better? While there is no clear answer for that, there is a critical concept in play here - “Diworsification”- a term coined by the famous investor Peter Lynch. 

Diworsification in investments is the practice of adding too many assets with similar correlations to a portfolio, which can negatively impact both risk and performance.

According to a study by Avendus Olivo, going beyond 30 stocks clearly does not provide additional benefits in the Indian markets.

Source: Avendus Olivo

 

Time Horizon	CAGR		Standard Deviation
	Sensex 30	Nifty 50	Sensex 30	Nifty 50
10 Years	12.1%	11.8%	17.1%	17.1%
20 Years	15.9%	15.4%	21.9%	22.1%

Source: Bloomberg, Avendus Olivo (Data as of 31 August 2023)

As the table above shows, going beyond 30 stocks does not provide additional benefits. Over the last 20 years, the returns and risks of all the indices have been similar, but the cost of holding index funds can create marginal differences.

For instance, according to a study by Value Research in October 2023, the Sensex outperformed the Nifty 50 on a 5-year rolling returns basis. This comes despite the fact that Sensex and Nifty are 86.67% Identical.

Hence, we opted to go for a Sensex-tracking Index Mutual Fund.

The Ultimate Choice

In the end, for index funds, everything boils down to 2 things - Expense Ratio & Tracking Error. You want an index fund that tracks the index more closely and has the lowest charges.

Among the Sensex-tracking Index Mutual Funds, one clear winner emerged.

Revealing our choice of large-cap funds for 2025 tomorrow in Recipe’s Free Reports section. Stay tuned!