Tilt portfolio towards largecap funds to tap reasonable valuations

Consider going for a passive fund

Mid and smallcap funds have been investors’ favourites in recent times. Since April 2022, they have pumped in Rs 33,486 crore into midcap funds, and Rs 48,650 crore into smallcap funds, according to data from the Association of Mutual Funds in India (Amfi). Over the same period, largecap equity funds have received barely Rs 3,398 crore.

However, investors’ perception towards large-cap funds may be changing. They received net inflows of Rs 723 crore in October 2023 after five consecutive months of net outflows.
 

Steady compounders
 

Funds investing a minimum of 80 per cent of their portfolios in largecap stocks are classified as largecap. “In this fund, an investor gets access to a curated portfolio from the universe of top 100 names in terms of market capitalisation. Since these companies are market leaders across sectors and are beneficiaries of industry growth, they tend to be steady compounders,” says Anish Tawakley, deputy chief investment officer-equity and head of research, ICICI Prudential Asset Management Company.
 

These funds should constitute the core of equity portfolios. “Largecap companies generally have strong brands and balance sheets. Their earnings growth is steadier compared to that of mid and smallcap companies. Consequently, their returns are likely to be less volatile,” says Abhinav H Sharma, fund manager, Tata Mutual Fund.
 

Returns lagging
 

Largecap funds have lagged behind mid and smallcap funds across most time horizons. Most active largecap schemes find it difficult to beat the benchmark. According to the S&P Indices versus Active (SPIVA) scorecard, over the three- and five-year period ended June 30, 2023, 86.2 per cent and 92.9 per cent schemes underperformed the S&P BSE 100 Total Return Index (TRI). 
 

Fund managers say investors should choose a fund in this category carefully. “When selecting an actively-managed largecap fund, check for consistency of performance over the long term. Even if a fund is consistently in the second quartile each year, there is a reasonable chance it will end up in the top quartile over a five-year period,” says Tawakley.
 

Time to invest
 

The bull market has created pockets of overvaluation in small and midcap stocks. Largecaps, on the other hand, are reasonably priced. “Valuations in the largecap space are closer to their long-term historical averages and are hence comfortable. The risk-reward is favourable. We are positive on their longer-term prospects,” says Sharma.
 

Their prospects could improve further. “Cooling of inflation would lead to interest rates coming down, driving earnings in this segment,” says S Sridharan, founder & chief executive officer, Wallet Wealth.
 

Choosing among largecap offerings
 

One option is to invest in a pure largecap scheme. Another is to go for a fund from the flexicap category which, on average, has a 72 per cent allocation to largecap stocks. Investors may consider a flexicap scheme with a sound track record and a stable fund manager.
 

The third option is to go for index funds and exchange-traded funds (ETF) that track indices like the Nifty 50 TRI and the Nifty Next 50 TRI.
 

Check the expense ratio and the tracking error while selecting an index fund or an ETF (lower is better).
 

Existing investors must rebalance
 

The bull run may have made many existing investors overweight on mid and smallcap funds. To rebalance their portfolios, they may sell a portion of their small and midcap holdings and invest the money in largecap funds. Doing so may, however, give rise to a tax liability (if capital gains exceed Rs 1 lakh in a year). To avoid this, investors may plough their incremental investments into largecap funds in a staggered manner via systematic investment plans. According to Sridharan, largecap funds tend to offer better capital appreciation over the long term, hence one must invest in them for at least five years.
 

 While conservative investors should allocate 60-70 per cent to largecap funds, those with moderate and aggressive risk appetite may allocate 50 per cent and 30-40 per cent respectively.