Large-cap funds, by SEBI's mandate, must invest at least 80 per cent of their assets in large companies. By definition, top 100 companies by market capitalisation are termed as 'large caps'. So, large-cap funds are a convenient way to take exposure to well-established, frontline companies across sectors.
At Value Research, we go a step further and don't restrict ourselves to SEBI-defined categories based on management style or market capitalisation. We believe that true categorisation should reflect how a fund is placed in an investor's portfolio and which types of investors should invest in it. Based on this, we have categorised large-cap funds as ideal for conservative growth. So, they are meant for investors who want to profit from the growth in equity but don't want to expose themselves to too much volatility.
The route to conservative growth
If we look at the five-year rolling returns over the last 10 years for large-, mid- and small-cap funds, we observe that on average large-cap funds have returned 10.55 per cent, while mid- and small-cap categories have delivered 14.3 and 15 per cent, respectively. That shouldn't be surprising, given the high-risk-high-return profile of mid- and small-cap funds.
However, if we assess the volatility in these funds over the same period, as measured by standard deviation, large-cap funds have delivered those returns at much lower volatility (standard deviation of 4.54) as compared to mid-cap and small-cap funds (7.64 and 8.77, respectively).
This reasonable-growth-low-volatility profile is what makes large-cap funds ideal for conservative investors.
Stability of large caps
The reason for the stability of large caps lies in their business robustness and resilience. These companies have established businesses, large market shares, solid supply chains and hence they can withstand an economic crisis better than smaller companies. However, since they are mammoths, they also tend to grow at lower rates as compared to mid and small caps. Mind you, this 'low growth' is relative to the growth of mid and small caps. For instance, over the last 10 years, TCS, HDFC Bank and Asian Paints - three large caps - have grown their revenues and profits at 18.0 and 16.4 per cent; 22.4 and 24.6 per cent; and 11.7 and 11.9 per cent, respectively - no mean feat.
If you look at the revenue and profit growth of the stocks constituting S&P BSE 100, BSE 150 MidCap and BSE 250 SmallCap indices for the June, September and December quarters of 2020, some interesting insights are obtained.
The last year was a testing one for businesses due to the outbreak of the pandemic and the lockdowns. Amid such times, when the economy was virtually shutdown in the quarter ending June, large caps arrested the fall in revenues and profits better than mid and small caps. As the economy reopened, the jump in September and December quarter numbers was significant, with mid caps outpacing the large caps. However, small caps couldn't match the growth rates of large caps.
This suggests that in economic downturns large caps suffer less and in economic turnarounds smaller companies tend to do better but then large caps don't do so badly. The curious case is that of small caps, which couldn't match the pace of recovery in large and mid caps. The possible reason behind this is that the pandemic and lockdown have been especially severe for small caps and many of them are still recovering.
Having established the usefulness of large caps, let's now move to the 'mode' of investing in large caps - active and passive funds.
The battle of supremacy
In the large-cap category, there is a fierce battle between the active and passive styles of fund management. Although the passive style seems to be winning the race, it is too early to write off the active one. Here are some trends that are playing a decisive role in this tug of war.
The assets under management of passively managed large-cap funds (including index funds and ETF variants) have surpassed those of their actively managed counterparts. The passives overtook the latter in the month of July last year and have been marching ahead since then. At the end of January 2021, the passives managed assets worth Rs 1.95 lakh crore (53 per cent share), while their active counterparts had Rs 1.73 lakh crore (47 per cent share) under their management. Interestingly, this shift has happened at a rapid pace. Just five years ago, index funds and ETFs were not even sixth of the size of their active counterparts. So, has the big moment for passive investing arrived in India?
Undoubtedly, investments by the Employees' Provident Fund Organisation (EPFO) in ETFs, which started in 2015, have provided a much-needed fillip to this trend. However, some other factors have also contributed to this. A study of the inflows and outflows in large-cap funds in recent years (as estimated by Value Research) highlights investors' dissatisfaction with the majority of actively managed funds.
Our estimates suggest that only a handful of actively managed large-cap funds, comprising Axis Bluechip, Mirae Asset Large Cap and Canara Robeco Bluechip Equity, have been witnessing respectable inflows on a net basis. Further, these funds have been able to stay ahead of large-cap indices consistently and therefore, investors are pinning their hopes on them. But many others in the active space are steadily going downhill.
In the ETF segment, the numbers convey the known story. The duo of SBI ETF Nifty 50 and SBI ETF Sensex, which are the beneficiaries of sustained inflows from the EPFO, accounted for about 97 per cent of the total inflows in the segment in 2020. So, despite all the discussions about the low-cost structure of ETFs, retail investors have yet to build confidence in them. Besides, when it comes to investing in ETFs, additional requirements for opening a demat account and a trading account possibly act as a deterrent for mutual fund investors.
However, when it comes to index funds, no such requirements are there. Hence, retail investors are steadily taking interest in them. The index funds of HDFC Mutual Fund, UTI and ICICI Prudential have been the prime beneficiaries, while some others have also been able to stake a claim in this growing pie.
Performance: Not so 'active'
Over the last five years, active funds have struggled to keep pace with the benchmarks. In 2016, their passives counterparts first outperformed them and since then, it has become a pretty secular trend. The year 2018 was a watershed when all but two active funds trailed the BSE 100 total return index. A narrow market rally centred on only a handful of stocks in the large-cap universe was cited as the reason for their performance woes. The actives did crawl their way back somewhat in 2019 only to stumble again in 2020. Going forward, the odds are stacked against them. Generating outperformance from a tightly defined universe of the top 100 stocks by market cap is going to be a tough task, more so when they will always be at a disadvantage on costs.
Costs: Advantage investors
The tussle between active and passive funds is ultimately rewarding for investors on the cost front. While investors already have quite a few good options in the frugal world of passives, the intense competition is forcing active funds to rationalise their expenses. Over the past three years, the expense ratios of regular plans of the actively managed large-cap funds have trended down by about 8 per cent, while those of direct plans have fallen by 16 per cent. In a category where it has become extremely difficult to generate alpha by even a small margin, savings on costs contribute meaningfully towards outperformance. It is, therefore, not a coincidence that you see the same consistent outperformers (the ones from Axis and Mirae) also rank among the least expensive ones.
In an otherwise pretty grim scenario for active large-cap funds, a handful of them are navigating the challenges. They have kept a lid on costs, beaten the benchmarks consistently through some deft fund management and as a result, have cornered almost all of the inflows into the active space. For others, time is running out.
The rise of passive funds is even getting reflected in our large-cap fund recommendations over the years. Since 2018, passive large-cap funds have made a healthy portion of our recommended large-cap funds. For full analyses of our recommended large-cap funds, see the April 2021 issue of Mutual Fund Insight.