Opt for direct or passive funds in large-cap space

As outperformance by fund managers diminishes, investors should move towards lower-cost products

A recent report by Ambit Capital says outperformance by active fund managers vis-a-vis their benchmarks is diminishing in the large-cap space. Retail investors need to make suitable adjustments to their portfolios in light of this development.

The Ambit report found that compared to the pre-2010 period (January 1991-December 2009), during January 2010-February 2017 period, there was a significant reduction in the alpha generated by large-cap active funds. The alpha fell from approximately three-four percentage points to 0-1.5 percentage point (on average) for 5-10 year holding horizons. Another key finding is that consistency of outperformance by active funds has also turned low in the large-cap space. 

Earlier, the SPIVA (S&P Dow Jones indices versus active funds) bi-annual report brought out by S&P BSE Indices had also noted that fund managers were finding it difficult to deliver persistent outperformance across market cycles. It had said that over a 10-year period (till end-2016), almost 55 per cent of large-cap funds underperformed their benchmarks. "The study found that alpha generation by active funds tended to be higher in bear markets and more modest in bull markets, which may be contrary to what investors would expect. It also found that active funds tended to outperform in trend-continuation markets, but underperformed when the market regime changed," says Akash Jain, associate director, global research and design, S&P BSE Indices. 

Outperformance by active funds is diminishing because the market is becoming more efficient. "The number of analysts covering large-cap stocks has gone up and hence the pricing of stocks has become more efficient," says Prashant Mittal, analyst at Ambit Capital. Owing to the internet and stricter regulations regarding information dissemination, any edge that fund managers had is diminishing. Adds Ankur Kapur, managing partner, Plutus Capital: "Fund managers in India have to show quarter-on-quarter results and are hence unable to take a long-term view, making it difficult for them to generate outperformance." 

The Indian market has, however, not yet become as efficient as, say, the US. Investors can continue to invest in active funds, but in their direct schemes, where the expense ratio is lower (1-1.25 per cent) than in regular funds (1.95-3.10 per cent). "Investors who have an advisor to select the funds and carry out asset allocation may opt for active funds. Those investing on their own should opt for passive funds," says Kapur. When choosing an active fund, assess its performance over seven to 10 years, and make sure the fund manager responsible for the performance is still around. 

Investors may also opt for passive funds, such as index funds and ETFs. Index funds (regular plans) have an expense ratio of 20-194 basis points (10-115 basis points for their direct counterparts). Index funds offer the advantage that you can do an SIP (systematic investment plan) in them, which introduces discipline in investing. 
 

Large-cap ETFs now have an expense ratio of 4-89 basis points (but you also have to factor in brokerage fee at the time of buying and selling). Among ETFs, many funds have very small transaction volumes. An ETF's market price can deviate significantly from its net asset value (the ideal difference should not exceed 40 basis points). This is not an issue in index funds. For a long-term investor, however, low volumes in ETFs may not be a big issue as volumes are likely to improve with time. Some ETFs already offer the advantage of very low cost and satisfactory volumes. Look for low expense ratio and low tracking error when buying any passive fund.   
 

The number of analysts covering the mid- and small-cap space has not risen as much as in large-caps. Fund managers stand a better chance of generating alpha here, hence stick to active funds in this space.