Why active large-cap mutual funds are losing their edge over passive funds

Why active large-cap mutual funds are losing their edge over passive funds

 

Not a day passes without a word on the active versus passive debate in the investment world. In the developed markets, passive funds have overtaken active funds. India, however, has largely remained a market for active funds, believing that the market can still deliver alpha (excess returns over the benchmark). 

While this may have historically been true and, is still true in certain segments, the large-cap category's ability to generate alpha calls for a re-look. 

Large-cap funds have witnessed a fall in alpha compared to the Nifty 50 Total Returns Index (TRI)—which includes dividends, and is the accurate benchmark for active funds—in recent years. 

The average 3-year rolling excess return generated by large-cap funds over Nifty 50 TRI between 2000 and 2007 was 4%. This shrunk to just 1% during 2008-2017. The recent Sebi guidelines now require funds classified as 'largecaps' to hold 80% of their portfolio in securities comprising the top 100 companies by market capitalisation and, if we follow this definition, the alpha portrayed could be even lower.

Large-cap funds' alpha has shrunk
Active large-cap funds' average alpha fell from 4% during 2000-2007, to 1% during 2008-2017.

 

 

Active large-cap funds were selected as per Value Research categorization.
Excess returns (alpha) over the benchmark, Nifty 50 TRI, have been calculated using average 3-year rolling returns of large-cap funds from Jan 2000 to Sep 2017. Source:ACE MF

So, what is causing this fall in alpha?

Fund size and portfolio overlap 

 With the rise in the number of funds and their sizes, large-cap funds, which typically hold 50-60 stocks, have witnessed overlap in portfolios and have become benchmark huggers. The return differential among large-cap funds was 10% in 2002-2007 and has shrunk to 2% over the last five years.


Huge AUMs have reined in alpha
Large fund sizes have led to overlap in funds' portfolios and has made many of them benchmark huggers.

 

 

The chart shows the collective rise in the assets under management (AUM) of large-cap funds.


Tracking error

 Large-cap funds' tracking error (risk relative to the benchmark) has also tumbled over the past 10 years. The average tracking error during 2001-2007 was 10%. It shrunk drastically to 3.8% during 2008-2017. This is not surprising.


The pressure of higher AUMs (assets under management) has led to managers becoming risk averse and finding comfort in benchmark hugging. In the new Sebi regime, as managers have to select 50-60 names from a limited universe of 100 companies, this problem will only compound.


Expense ratio

 Expense ratios have not come down even as the average alpha has fallen. The average expense ratio of large-cap funds was 2.35% in August 2017—the average excess returns were 2.9% for the 3-year period ending in August 2017. This means that gross alpha was 5.25%, and half of it was eaten away by fund management fee!

 

Alpha still persists in mid- and multi-caps

 These funds score in terms of risk-adjusted performance and alpha. The information ratio, which essentially displays the risk-adjusted performance of a fund, is low for large-cap funds as compared to multi-cap funds—10-, 5- and 3-year information ratios for large-caps are 0.47, 0.34 and 0.31 respectively; for multi-caps the ratios are 0.75, 0.65 and 0.78.
 

Mid-cap stocks are less well tracked by analysts and managers still focus on bottom-up stock picking, taking large active weights relative to the benchmark, which is why alpha persists in this category and is likely to. Large-caps as a category will be a significant part of the investors' allocations, given that mutual fund penetration is taking off, it is important for the industry to get this asset class right. 

The traditional benchmark-hugging large-cap funds have to become more cost-efficient, given their shrinking alpha, else they will be replaced by passive and smart beta funds, which have already won the performance battle globally. 

Investors should look at the large-cap category for cost-efficient, market-plus returns and, for high alpha, turn to the multi- and mid-cap categories. Within multi- and midcaps, they should focus on funds that significantly deviate from the benchmark. 

Investors can also look at a growing set of non-traditional sources of large-cap exposure, including alternative funds and dynamic equity allocation funds which don't hug the benchmark and deliver superior risk-adjusted returns.

Happy Investing

Source:Moneycontrol.com

 

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