Well-Suited for the Long Haul

If one goes by the textbook definition, then large-cap mutual funds are those that invest only in large-cap stocks. In reality, barring a few exceptions, identifying large-cap funds is not easy. This is owing to different interpretations of what is a large-cap stock (different investors go by different definitions). Varying market conditions add to the confusion: in a falling market even some mid- & small-cap funds turn into large-cap funds. Then there could be ambiguity about the nature of a particular fund: for instance, is a fund with a small exposure to mid- and small-cap stocks a large-cap fund or a multi-cap fund?

At Value Research we looked at the half-yearly portfolios of equity funds for the past three years and identified large-cap funds as those that invest 80 per cent or more of their assets in large-cap stocks. (We define large-cap stocks as those largest market-cap stocks that together account for 70 per cent of total market capitalisation). Based on this definition, we got a selection of 50 funds, which includes 33 rated funds and 17 unrated ones.

Apt for core holding
As we have discussed earlier also, the core of your portfolio should be comprised of investments that can hold their ground regardless of the direction of the markets. If you are investing in equity, then your portfolio cannot obviously be market neutral. But over the years large-cap funds have proven themselves to be far better protectors of downside risk than other types of equity funds.

What makes large-cap funds suited for your core holding is the universe of stocks that they invest in. Large-cap companies are generally mature, cash-rich and regular dividend-paying companies that have predictable growth rates. But make no mistake. Since India is a rapidly-growing economy, large-cap funds here are not as stodgy and slow-growing as is the usual perception about them in the developed world. The average five-year profit growth rate of the 50-largest large-cap companies in India is 24 per cent. Of these the slowest grew at -231 per cent (Suzlon Energy) while the fastest grew at 66.84 per cent (Dr. Reddy’s Lab). Most of these large-cap companies are still in the growth stage.

Another attractive feature of these companies is that they have a low level of leverage: the average debt to equity ratio of Nifty companies (excluding banks) is 0.70 times. These companies are also cash-rich: they have an average cash per share of `80.37 which is equivalent to 12 per cent of their cumulative stock price.

Moreover, unlike small-cap stocks, large caps are the most well-researched stocks in the markets. There is very little room for benefiting from information arbitrage, but this also means that there is very little chance of stock prices moving significantly away from their underlying value. This makes large-cap stocks less volatile.

Characteristics of large-cap funds
Large-cap funds tend to have compact portfolios: over the last one year the average number of stocks in the portfolios of these funds was 39. DSPBR Top 100 Equity held the largest number of stocks at 42, while Reliance Quant Plus held the smallest number of stocks at 13.

Differences among these funds arise out of how they define their investment universe. Kotak 30, for instance, defines its universe as the top 30 stocks by market capitalisation while DSPBR Top 100 defines it as the 100 biggest companies by market capitalisation.

By and large most large-cap funds (excluding index funds and ETFs) keep a small portion of their portfolio, around 12 per cent, exposed to mid- and small-cap stocks in order to enjoy a performance kicker.

Are they better than ETFs?
Since the large-cap space is so well researched, a question that arises is whether fund managers will be able to sustain alpha, i.e., generate outperformance, consistently. It could be argued that in the long run the returns of large-cap funds should equal that of index funds or ETFs mounted on the indexes comprising frontline stocks, such as Sensex and Nifty.

So far in India the numbers do not attest to the superiority of passive funds over the long term, as is the case in the West. If one compares the annual performance of large-cap funds with that of the Nifty in the last 10 years, then one would find that other than in 2007 and 2009, large-cap funds have outpaced the index in almost all the years. The 10-year returns (till Ocotber 15, 2010) of the benchmark indices Nifty and Sensex are 17.81 per cent and 18.33 per cent respectively. Compare this to the category average return of large-cap funds (excluding passively-managed funds): they earned a return of 23.20 per cent over this period. The worst-performing fund delivered a return of 20.26 per cent while the best-performing fund delivered a return of 27.48 per cent. Thus, even if you had invested in the worst-performing fund in the category, your returns would have been higher than those of ETFs or index funds.

Strategies for generating outperformance
Since their stock universe is limited, one of the ways through which these funds try to generate outperformance is by going overweight or underweight on the stocks present in the benchmark. Take the example of IDFC Imperial Equity. It maintains a tight portfolio of around 28 stocks out of its universe of top 70 stocks by market cap. It has been able to outperform its benchmark (Nifty) by either going overweight or underweight vis-a-vis the weights assigned in the benchmark. Though this strategy has at times landed the fund in trouble in the short term, in the long term this conservative strategy has paid off handsomely.

Other funds practise a hybrid version of this strategy. They dilute their large-cap exposure by including a small dose of mid- and small-cap stocks in order to boost their returns. A fund like HDFC Sensex Plus keeps 80-90 per cent of its portfolio in Sensex stocks in nearly the same proportion as the index, but keeps the balance 10-20 per cent in stocks that give that extra fillip to the fund’s returns. For the past one year it has kept around 12 per cent of its portfolio in mid- and small-cap stocks. The result: over the past five years (till October 15, 2010) the fund clocked a return of 22 per cent compared to 15 per cent for the Sensex.

Some fund managers pursue a target return based strategy. They pick an undervalued large-cap stock, only to exit it as soon as their target price is achieved. Apoorva Shah, the fund manager of DSPBR Top 100, confirms that he follows such a strategy. He defends his strategy saying: “In such a well-researched space, one does not have to buy and hold for long since price targets are achieved rapidly.” In addition, keeping the core portfolio intact, he takes calls based on fund flows and news that could have a material impact on stock price.

In practice, most funds in the category follow a mix of these three strategies. It is rare to find a fund following a single strategy.

For all the above-mentioned reasons, constituting the core of your portfolio with large-cap funds having a sound long-term track record is a smart proposition.

This article was originally published on December 20, 2010.