If you look at the performance of large-cap funds over the past one year, the majority of them have underperformed their benchmarks.
This raises the question whether investors should move into low-cost exchange-traded funds (ETFs) and index funds in the large-cap space. Several factors are responsible for this phenomenon of underperformance by largecap active funds. One is the high cost of these funds. The average expense ratio of large-cap funds in the regular category is 2.37 per cent. Fund managers need to create outperformance of more than this amount on a gross basis to be able to show alpha on a net basis.
The largecap space is also very well researched now. Foreign institutional investors (FIIs) tend to prefer this segment of the market. With these stocks being so heavily tracked, it has become very difficult for active fund managers to outperform in this category.
The Securities and Exchange Board of India (Sebi) has now stipulated that fund managers should benchmark their returns against the total return index (TRI) instead of the price return index (PRI). The TRI includes dividends as well. This has made it even harder for fund managers to beat their benchmarks.
Moreover, 2018 was a peculiar year. The returns of the large-cap indices were driven by a just a few heavyweight stocks. If fund managers did not have exposure to these select stocks, they underperformed. Moreover, the weights of these stocks needed to be higher in their portfolios than in the index for them to be able to outperform. Fund managers, for safety-related reasons, cannot have such concentrated exposures to just a few stocks.
One way that fund houses can address this trend of lower outperformance by large-cap stocks is by bringing down the expense ratios of their largecap funds. Some fund houses like Edelweiss have already done so.
What should you do?
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