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Investors often find themselves at crossroads when trying to choose between actively managed large cap funds and passive index funds. While the actively managed funds seem more attractive with promises of higher Alpha through skilled stock selection and market timing but the reality often falls short.
Large cap funds invest in selected top tier companies by market capitalization which are often marketed as safe funds which are expected to give greater returns as compared to a large cap index fund because it has the added edge of active management.
At Sapient Finserv, we compared the category average performance of large cap funds and the data from the past several years and it shows that their returns tend to be lower than those of passive index funds like the NIFTY 100 Equal Weight Index Fund.
The NIFTY 100 Equal Weight Index Fund distributes its investments equally among the top 100 companies, offering a diversified approach without the bias towards the largest market capitalizations. This strategy mitigates the risk of any single stock disproportionately affecting the portfolio.
While HDFC NIFTY 100 Equal Weight Index Fund-Reg(G) is comparatively new, Sundaram NIFTY 100 Equal Weight Fund(G) was launched on 27 th July, 1999. We have compared the 5-year performance of this fund with that of the average of large cap funds and it revealed this:
These figures illustrate that the equal weight index fund outperforms the average large cap fund. While this might seem marginal on the surface, the compounding effect over time results in significantly higher cumulative returns for the index fund investors.
Large cap funds typically have higher expense ratios due to the costs associated with active management, research, and frequent trading. In contrast, index funds, being passively managed, incur lower expenses.
Average expense ratio of large cap funds: 2.03%
Expense ratio of Sundaram NIFTY 100 Equal Weight Index Fund (G): 1.03%
The difference of 1% in expense ratios might seem negligible, but over a long-term investment horizon, this can erode a significant portion of the returns.
Given the higher fees, the logical expectation is that active management would justify its cost through superior returns. However, evidence suggests otherwise. The inherent challenge for fund managers is consistently outperforming the market, especially after accounting for fees and taxes.
Large cap funds are often considered a safe haven due to their investments in well-established, financially stable companies. This makes them a relatively lower- risk option in a diversified portfolio. However, for investors seeking only large cap exposure, index funds can be a better option due to their lower costs and competitive returns.
While index funds provide a strong case for large cap exposure, diversified funds like flexi cap, large & mid cap, and focused equity funds remain crucial components of a well-rounded portfolio. These funds offer the potential for exponential returns by investing across different market capitalizations, sectors and themes. Active management in these diversified funds can be particularly valuable, as analysing mid and small cap companies requires extensive research and expertise that a layman investor may not possess.
Ultimately, a balanced approach incorporating both passive index funds for large cap exposure and actively managed diversified funds can provide the best of both worlds in terms of stability and growth potential.
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