Should You Invest in Nifty Index Funds as Large Cap Mutual Funds Underperform?

Apr 28, 2023 / Reading Time: Approx. 6 mins

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A large number of actively managed Large Cap Mutual Funds have underperformed their benchmark indices in the last few years. Meanwhile, Nifty Index Funds, i.e. the funds tracking the Nifty 50 index, have fared better.

[Read: How Has the Year 2022 Been for Active Funds and Index Funds]

In the last 5 years, Nifty Index Funds generated average returns of 11.7% CAGR. On the other hand, the Large Cap Mutual Fund category generated average returns of about 11%. It is noteworthy that 16 out of 27 Large Cap Mutual Fund schemes underperformed their respective benchmark indices, while 5 others generated returns nearly on par with their benchmark. In other words, nearly 80% of actively managed Large Cap Mutual Funds failed to generate a decent lead over the benchmark. Only a handful of schemes generated an alpha of about 1 percentage point or higher compared to their benchmark.

Nifty Index Funds outperformed actively managed Large Cap Mutual Funds

Category Average 5-Yr returns (CAGR %)
Nifty 50 Index Fund 11.74
Large Cap Mutual Fund 10.97
Past performance is not an indicator for future returns
Data as of April 27, 2023
(Source: ACE MF)

Why are actively managed Large Cap Mutual Funds underperforming?

In 2018, market regulator SEBI introduced categorisation norms for mutual funds to ensure that schemes remain true to label. This created challenges for actively managed funds to create alpha since it limited the universe of stocks from which a scheme belonging to a particular category could invest. Earlier, Large Cap Mutual Funds dynamically allocated assets across the market cap range while maintaining a large-cap bias. Now, the investment universe of Large Cap Mutual Funds is limited to the top 100 companies where they invest at least 80% of their assets, leaving less room to generate high returns.

Mutual fund norms also require actively managed schemes to follow a single stock limit of 10% to avoid concentration risk. This prevents them from taking full advantage of the rally in these select stocks if it grows beyond the specified limit.

Therefore, a significant number of actively managed mutual funds have not only found it increasingly difficult to generate sustainable alpha but have also underperformed their respective benchmark indices. This, in turn, has elicited investors' interest towards passively managed funds.

Performance of Large Cap Mutual Funds relative to the benchmark

Large Cap Mutual Fund 5-Yr returns (CAGR %)
Top performing Large Cap Mutual Fund 14.09
Bottom performing Large Cap Mutual Fund 7.34
NIFTY 100 - TRI 11.12
S&P BSE 100 - TRI 11.80
Past performance is not an indicator for future returns
Data as of April 27, 2023
(Source: ACE MF)

Moreover, the relatively higher expense ratio of actively managed schemes eats into the returns to an extent, thus reducing the scope of high alpha. Notably, since Large Cap Mutual Funds invest in market leaders, the scope of high returns is limited.

So does the high underperformance rate of Large Cap Mutual Funds make a case for choosing passively managed Index Funds over actively managed schemes?

Passive funds provide a low-cost investment offering for investors looking to earn decent returns from equities by tracking the respective benchmark index and/or underlying fund, making it ideal for new investors who have just started their investment journey or those who do not want to undertake relatively higher risk. It is also a simple and convenient option for investors who find it difficult to choose the right fund from the plethora of available active funds.

So, if you are looking to earn returns in line with the market, consider investing in Index Funds that track large-cap indices such as Nifty 50, Nifty Next 50, Nifty 100, S&P BSE Sensex, etc.

However, do note that it is not the end of the road for actively managed Large Cap Mutual Fund schemes, and they may make a comeback soon.

[Read: 3 Best Large Cap Mutual Funds to Invest in 2023 - Top Performing Large Cap Mutual Funds in India]

Should You Invest in Nifty Index Funds as Large Cap Mutual Funds Underperform?
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A fund manager of a worthy well-diversified open-ended Large Cap Mutual Fund that follows robust investment processes and systems may still reward investors well in the future. Unlike passive funds, actively managed funds are better poised to take advantage of dynamic market conditions and make tactical allocations in attractive-looking stocks/sectors/market cap, depending on the outlook. This enables actively managed schemes to limit downside risk.

So, if you are looking to beat the benchmark index and potentially earn better real returns (also known as inflation-adjusted returns), an actively managed fund is certainly a better choice. Active investing will continue to be relevant in this day and age of intensified volatility and macroeconomic risk alongside geopolitical uncertainty.

[Read: What Should Be Your Mutual Fund Asset Allocation Strategy Amid Rising Global Uncertainty]

As an investor, you can consider investing in a mix of Nifty Index Funds and well-managed Large Cap Mutual Funds to create a diversified portfolio that will help you tide over volatile market conditions.

When you build a portfolio of mutual funds, assess your financial goals, investment time horizon and risk appetite, and invest accordingly to create an optimally diversified portfolio. While selecting Index Funds, pick the one with a low expense ratio and low tracking error to optimise the returns.

More importantly, when you invest in equity funds, ensure that you have a time horizon of 5-7 years and prefer the SIP mode of investment to benefit from the compounding of wealth. And lastly, avoid investing in too many schemes as it can make it difficult to monitor its performance and eliminate the laggards.

DIVYA GROVER is the co-editor for FundSelect, the flagship research service of PersonalFN. She is also the co-editor of DebtSelect. Divya is an avid reader which helps her in analysing industry trends and producing insightful articles for PersonalFN’s popular newsletter – Daily Wealth letter, read by over 1.5 lakh subscribers.

Divya joined PersonalFN in 2019 and has since then used stringent quantitative and qualitative parameters to analyse funds to provide honest and unbiased research to investors. She endeavours to enable investors to make an informed investment decision and thereby safeguard their wealth.

Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.

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