A lot of investors today are often faced with a singular question: Should I invest in index funds only or should I also choose actively managed equity funds? Fortunately, there is space for both strategies in the portfolios.
The key is to strike the correct balance between them to create an optimal portfolio.
Passive Exposure in Large-Cap Investing
As per official SEBI categorisation, large-cap stocks are the top 100 stocks in India by market capitalisation. These represent established companies often leading their respective industries. Investing in largecaps provides stability, as these companies are relatively insulated from market volatility compared to their smaller counterparts.
One effective way to gain passive exposure to largecaps is through index funds or exchange-traded funds (ETFs) that track benchmark indices like the Nifty 50 or the Sensex. These passive instruments offer a cost-effective and low-risk method to align with the overall market performance.
Why Passive Exposure?
1. Well-researched: These stocks are well-researched by leading analysts/brokerages with adequate coverage of them. And therefore, the information asymmetry does not exist. Everyone is dealing with the same set of information.
2. Limited levers for alpha generation: The fund manager is limited to investing in the top 100 companies with at least 80% of the exposure to largecaps. This limits the manoeuvrability of the manager to seek ideas outside the investible universe. The only way it can beat the benchmark is by being underweight/overweight on a stock vis-à-vis the benchmark.
3. Diversification: Investing in an index fund provides instant exposure to a diversified basket of large-cap stocks, reducing individual stock risk.
Performance Comparison: Active Large-Cap Funds vs. Benchmarks
Over the past decade, data reveals a consistent trend of active large-cap funds underperforming their respective benchmarks. According to a study by S&P Global, approximately 94% of large-cap funds in India have failed to beat their benchmark indices over five years.
This underperformance can be primarily attributed to two factors:
1. Higher expense ratio: The average expense ratio of an active large-cap fund is 1.9% compared to that of 0.3% of the Nifty50 index fund.
2. High portfolio overlap: Due to the limited investible universe, most of the large-cap funds have a very high portfolio overlap with an index like Nifty50. On average, 60% of the stocks are similar to the index.
Due to the above factors, recent research conducted by FundsIndia revealed that active large-cap funds must provide an outperformance of 5-7% every year on the active share portion to beat the index by 1%.
Active Exposure in Mid/Small-Cap Investing
Mid and small-cap companies, on the other hand, represent companies from 101st-500th in terms of their market capitalisation. These companies often operate in specialised sectors with substantial room for growth. While they present higher volatility and potential drawdowns, they also offer room for significant returns.
Actively managed mutual funds focusing on mid and small-cap segments can be an effective tool for investors seeking alpha beyond market benchmarks. Skilled fund managers/houses apply in-depth research and analysis to identify promising companies with high growth potential.
Why Active Exposure?
1. Alpha generation: Active fund managers have the flexibility to move in and out of stocks based on market conditions and their analysis of individual companies. Since they have a much larger universe to choose from, there is a greater scope for the manager to beat the benchmark.
2. Exploiting market inefficiencies: In the mid and small-cap space, there exists significantly greater information asymmetry, providing opportunities for astute fund managers to uncover undervalued gems.
3. Potential for explosive growth: Some of India's most successful companies today were once mid or small-cap stocks. An active approach allows investors to tap into this growth potential.
Conclusion
A blend of passive exposure in largecaps and active exposure in mid and smallcaps can be a prudent investment strategy. Large-cap stocks provide stability and resilience, while mid and smallcaps offer the potential for higher returns.
However, it's crucial to recognise the strengths and weaknesses of both approaches and construct a well-balanced portfolio aligned with your risk tolerance and investment horizon. Ultimately, a judicious mix of passive and active investing can pave the way for long-term wealth creation in the stock market.
Varun Fatehpuria is the Founder & CEO of Daulat.
