Investors should split large-cap allocation between active, passive funds

Fixed-income investors should be in funds that limit both credit and duration risk

Mutual fund investors, both in debt or equity, are in a quandary today. The category average returns from their systematic investment plans (SIPs) in actively managed large-cap funds over the past one year stands at -1.39 per cent. An investor in a Nifty 50 index fund would, on the other hand, have made 4.39 per cent (category average return). On the fixed-income side, net asset values (NAVs) of many debt funds have been hit by events surrounding Infrastructure Leasing & Financial Services (IL&FS), Zee and DHFL groups. A lot of investors would be worried, and seeking advice if they should move to passive funds in the equity domain and to the safety of fixed deposits (FDs) on the fixed-income side. 

Last year was an aberration: As far as the underperformance of large-cap active funds goes, experts say that the past one year was an aberration. Within the large-cap space, the performance of the index was driven by just five-seven heavyweights such as HDFC, HDFC Bank, Reliance, Bajaj Finance, Infosys and TCS. The rest of the large-cap universe gave either flat or negative returns. Fund managers running diversified portfolios hold at least 30-40 stocks. If they did not have exposure to these index heavyweights, or had lower weightage to them than in the index, as is likely, they would have underperformed. “One year is too short a period of time to judge the performance of active funds, and this trend of narrow market rally could well change in the future,” says Anil Ghelani, senior vice president and head of passive Investments, DSP Investment Managers.  

Alpha generation  by large-cap active fund managers may not have vanished altogether, but it has been shrinking and may continue to do so. “After the re-categorisation exercise, and with the size of assets under management (AUM) growing, large-cap fund managers will find it increasingly difficult to generate alpha,” says Kaustubh Belapurkar, director-manager research, Morningstar Investment Adviser India. The leeway to do so has shrunk after the Security and Exchange Board of India’s recategorisation exercise. Now large-cap fund managers can only take exposure of up to 20 per cent of their portfolio in mid- and small-cap stocks. The shift from price return index to total return index as the benchmark has also made it harder for large-cap active fund managers to outperform 

Start taking exposure to passive funds:  So far, however, outperformance by large-cap active funds has not vanished entirely. “You need to identify quality active fund managers, with the help of an advisor if need be, and then give them at least a five-seven-year timeframe to perform,” says Belapurkar. Select funds that have a track record of consistent calendar-year wise performance, and have a relatively lower expense ratio. 

According to Ghelani, you should have a complementary allocation to both active and passive funds at present in the large-cap category. “Don't stop your SIPs in actively managed funds. Any incremental amount you may invest may go into passive funds,” he adds.  

In the mid- and small-cap space, the universe of stocks is much larger (there are 150 stocks in the midcap space and all stocks beyond 250 ranked by market cap are small-cap). This larger universe of stocks is not yet as rigorously researched, so there is still scope for outperformance by fund managers here. Moreover, there are very few passive fund or exchange traded fund options available at present in the mid- and small-cap space. 

Credit risk comes to the fore: On the fixed-income side, investors, who have experienced interest-rate risk, are now experiencing credit risk like never before. Net asset values (NAVs) of many funds have been affected by defaults, downgrades, and the risk of future defaults. Experts say that part of the blame lies with the credit “Both banks and mutual funds are lenders to corporates. The banking system has been struggling with non-performing assets (NPAs) for several years now. It is only natural that some of the stress within the economy gets reflected in debt fund portfolios as well, as they too lend to the same set of corporates,” says Akhil Mittal, senior fund manager (fixed income), Tata Mutual Fund. The silver lining, according to him, however, is that barely 1-1.5 per cent of the AUM of debt funds has been affected by these problems, large part of which is expected to come out the current issues and stay good.

Debt funds offer the diversification benefit and should hence be preferred over options like corporate fixed deposits and non-convertible debentures (NCDs). “An investor gets exposure to multiple companies for a small amount of money. Even if there are issues with a company or two, the rest of the investment is protected and offers gains,” says Malhar Majumder, founder, Positive Vibes Consulting and Advisory.

Select debt fund categories carefully: After these developments, investors need to stop thinking of debt funds as fixed deposit like products that offer higher returns (as many have in the past). “The major portion of a conservative investor’s allocation should be to those debt funds that control both duration and credit risk,” says Suyash Choudhary, head-fixed income, IDFC Mutual Fund. Broadly, this means that you should stick to funds that invest largely in AAA bonds and have an average maturity of two-five years. Banking and PSU bond funds are another safe category you may consider. Exposure to high-risk categories like credit risk funds should be taken only by investors who have the necessary risk appetite, and in limited amounts, via the direct route. Avoid debt funds with exposure to a single promoter group exceeds 5 per cent.  

A complete exit from debt funds to the safe haven of fixed deposits may not be necessary. “Remember that there is a tax arbitrage between debt funds and fixed deposits. If you hold the former for three years, you get an indexation benefit and pay minimal tax. On a post-tax basis, debt funds usually make more sense,” says Belapurkar. 

For ultra-conservative investors, who do not have any taxable income, or are in the lowest tax bracket, fixed deposits may make sense. Also, investors who are risk-averse may stick to FDs.