The S&P BSE Sensex has surpassed the 61,000 mark and the Nifty 50 index is trading above the 18,000 level. These large-cap indices have more than doubled since the March 2020 low, growing by around 135% in absolute terms (as of Oct 25, 2021).

Since the beginning of 2021, the Sensex has gained 28%; the Nifty 50 rose by 30% during the same period.

This sharp rally in the large-cap indices, however, has not brought much cheer to many investors in the Large-cap mutual fund category. Despite Sensex at lifetime high, around 45% of the large-cap schemes have underperformed their respective benchmarks in the last 1-year period. Even on the longer 2-year, 3-year, and 5-year periods, several large-cap funds have trailed their benchmark index.

Moreover, the margin of underperformance between the worst performing mutual fund and the benchmark as well as compared to the top performing mutual fund has been quite sharp (see table below). Notably, a majority of large-cap funds witnessed a rough patch in the past couple of years which has consequentially impacted its returns across time frames.

Table: Many Large-cap Funds underperformed their benchmark indices

Large-cap Funds Absolute (%) CAGR (%)
1 Year 2 Years 3 Years 5 Years 7 Years
Top performing fund 66.45 30.03 27.32 19.98 16.83
Worst performing fund 40.03 18.39 16.58 10.54 10.24
Category average 53.53 25.48 22.43 15.53 14.10
Nifty 50 – TRI 53.62 26.35 22.80 17.25 13.72
Category underperformance rate 45.16% 44.83% 71.43% 59.26% 18.52%

Data as on October 25, 2021
Direct Plan – Growth option considered
(Source: ACE MF, PersonalFN Research) 

The following reasons are why many large-cap mutual funds have been underperforming:

Not all large-cap stocks have rallied in the past couple of years. The equity markets were polarised over the last few years where only a few top names in the large-cap segment witnessed significant growth. However, since actively managed funds restrict the maximum allocation in any individual stock to avoid concentration (over-exposure) risk, the returns on these funds were lower than the index returns.

The SEBI’s classification norm for mutual funds has also made it difficult for large-cap funds to generate alpha. Large-cap funds hold the mandate to invest minimum 80% of its assets in the top 100 companies by market capitalisation. Earlier, these funds had the flexibility to invest across market caps wherever opportunities existed as long as they maintained a large-cap bias.

Actively managed Large-cap funds do not mirror the constituents of the indices in a bid to outperform the market. Fund managers decide the allocation towards respective stocks and sectors depending on the outlook, valuations, among other factors. Therefore, the performance of these funds can deviate from the index. However, this approach may not always work in their favour due to dynamic market conditions.

Equity markets are cyclical in nature. At times, a scheme may not be agile enough to capitalise on the shift in the cyclical rotation or to identify the next set of winning stocks. For instance, most large-cap funds were underweight on IT and Pharma sector when the pandemic caused a sudden shift in consumer preference. Funds increased exposure to the sector only later, causing them to miss the initial leg of the rally. Thus, these funds could not fully cash in on this shift at the time of the sectoral rotation.

Besides, the performance of a large-cap fund to a large extent depends on the strategy that the scheme adopts. Some fund managers prefer to periodically churn the portfolio depending on the market conditions, while others follow the buy-and-hold philosophy by investing in stocks that the fund manager has conviction for (even if the stocks are currently out of favour).

Both these strategies have the potential to generate handsome returns for investors over the long term, though the short-term performance can vary significantly.

Consider this, HDFC Top 100 Fund, one of the oldest and popular large-cap funds, hit a rough patch in the last couple of years. The fund follows a value-oriented investment strategy, and accordingly holds several undervalued stocks, such as those of public sector enterprise, in its portfolio.

As you may be aware, value stocks languished in the last few years amid weak economic growth. However, since many value stocks have shown a sharp recovery in the last one year, the HDFC top 100 Fund has witnessed visible improvement in its performance. It now stands among the top quartile performers in the 1-year period.

On the other hand, the Axis Bluechip Fund, a growth-oriented large-cap fund that has been topping the returns chart for quite some time now, has trailed many of its peers in the last one year.

Many growth-oriented stocks are currently trading at high valuations and have run ahead of the fundamentals. This has impacted the short-term performance of many growth-oriented large-cap funds.

What should investors do?

Investing in large-cap mutual funds provides better protection against volatility compared to mid-cap funds and small-cap funds, in case of market correction. You also benefit from the steady growth of capital over the long term. Therefore, large-cap funds should form part of the core segment of every investor’s portfolio.

Notably, Mid-cap Funds and Small-cap Funds have outperformed Large-cap Funds in the recent months. However, if the market corrects, mid-cap and small-cap stocks are likely to be affected the worst and the investors’ sentiment could shift in favour of large-caps. This could potentially improve the performance of large-cap funds.

The Indian equity market will continue to offer alpha generating opportunities that fund managers of actively managed large-cap funds can take advantage of. Many well-managed large-cap funds have created significant wealth for investors and could potentially continue to do so in the future.

Therefore, choose large-cap funds after you have evaluated it on various quantitative and qualitative parameters. Investors who wish to earn returns in line with large-cap indices such as Nifty 50 can consider investing in low-cost alternatives such as Index Funds or ETFs.

If you are holding underperforming large-cap funds in your portfolio, determine whether the scheme has consistently trailed the benchmark and most category peers. Consider exiting the scheme and replace it with a better performing one instead, particularly if it has consistently fared poorly on risk-reward parameters over the long-term.

However, if the underperformance is only seen in the short term, you can continue holding the scheme. Remember that loads and/or taxes may apply when you redeem your investment.

This article first appeared on PersonalFN here

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