Index Vs Large Cap funds — Can Index funds be a viable replacement for Large cap funds?

To make the life of investors easier, at the beginning of this year, SEBI came out with a few regulations. The two most important aspects of it were the definition of market capitalisation as well as the 16 categories under which AMCs can launch mutual funds. 

As per these changes, large cap funds are the ones which are hit the most. Not only has SEBI mandated that the top 100 stocks by market capitalisation come under the definition of large cap but also that this is the only universe from which fund managers can pick and invest in. 

Index funds, on the other hand, are mutual funds which mimic the index and invest in stocks in the same proportion with no human intervention. Index funds have been an extremely popular type of investment in the US. Legendary John Bogle took the concept of low-cost index investing to next level and made Vanguard a household name for index investing in US. With the changes outlined above, let’s look at a comparison between index funds and large cap funds and how index funds might be a better bet.

1. Low cost

The biggest selling point for any index fund is the much lower expense ratio. Since there is no fund manager using inputs or making decisions on the investments, this is reflected in the expense ratio. 
When you compare the large cap fund and an index fund of the same AMC or fund house, the difference is often almost 1%. So, on a base of a low expense ratio of about 0.30%, the expense ratio for a large cap fund is 3 times that of an index fund. Over the years, these expenses eat into the returns of the funds.

2. Less churning with passive management

Most mutual funds are known for the high level of churning. When there is fund manager, looking at the holdings, day in and day out, they are bound to try everything, resulting in more transactions. This is also known as the turnover ratio, where a figure of 100% implies that the entire portfolio is churned once every year. A lot of mutual funds have this turnover ratio as more than 100%. Such turnover not only comes with a high brokerage cost but also gives very little time for any stock to show returns.

On the other hand, changes in the indices happen at a far less frequency. The frequency is so low that a change in the index ends up making headlines. So, index funds allow stocks to show results and also end up with much lesser brokerage cost thanks to the lower turnover ratio.

3. Percentage of large cap covered in the index (Sensex and Nifty)

The two biggest indices for large cap stocks are the Sensex on BSE and Nifty 50 on NSE. Sensex consists of 30 stocks whereas Nifty 50 consists of the top 50 stocks listed on NSE. Both the indices cover over 65% market cap of the large cap universe in either exchange. Any index fund tagged to these indices manages this coverage as well.

4. No variance between fund houses

While we often know which category of mutual fund we want to invest in, analysis paralysis often occurs just in the choice of AMC or mutual fund house to invest with. 

Investing with index funds is a far simpler choice since there is no difference in returns between fund houses. All fund houses are offering the same investment and the returns will be exactly the same. The only slight difference might be in the expense ratio and that needs to be your only factor in consideration. 

5. Transparency

One of the mystical aspects of mutual funds is the logic employed while managing it. As investors, we are barely aware of how the fund is constituted. On the other hand, with an index fund, not only is the composition always available, the reason for any stock’s inclusion or exclusion is crystal clear considering how widely it is covered in the press.

6. Outperformance against TRI Benchmark much lesser

Till a few months back, when mutual funds compared their performance to the index to which they were benchmarked, it was compared to Price Return Index or PRI. PRI had a limitation of not including dividends in the returns, whereas fund managers do include dividend yields in their returns which led to a sharp outperformance for them as compared to a benchmark. 

Since Feb 2018, SEBI has mandated the use of Total Return Index or TRI which includes dividend yield as part of the calculation for returns. In most cases, PRI and TRI have a difference of around 1.5%. This has brought about much more transparency for the investors when it comes to comparing any fund with respect to its index performance. Check any large cap fund today and you will see that the additional returns apart from the index are now pretty minimal, if at all.

To be fair to large cap funds, SEBI does permit them to experiment with 20% of the portfolio which can be chosen from beyond the Top 100 stocks by Market capitalisation. Hence, the only hope is that a reasonable alpha generation happens in this category from this 20% allocation. But nonetheless, it will incrementally get very difficult for Large Cap funds to consistently beat Index owing to all the factors mentioned above.

As you can see, index funds add much value to your portfolio by covering the large cap universe at a much lower cost and with far less churning. When you now consider any large cap funds, do not miss checking out index funds as a viable option. 

Check out Nifty based index funds with Moneyfront research here .