How are index funds different from large-cap funds?

Large cap funds seem to perform in line with index funds. Are they similar in any way? Should you look at large cap funds or index funds?

Kavya Balaji   /   May 8, 2020
Large Cap Fund

Over the last couple of years, there have been talks about how index funds are performing better than actively managed mutual funds. First, let us look at why some of the large cap funds are just not able to beat the benchmark index.

Index fund vs large cap fund

A few years back, the Securities Exchange Board of India (SEBI) recategorised mutual funds. Why? This was to make sure that different schemes launched by mutual fund houses are clearly distinct in terms of asset allocation, investment strategy etc. Further, this was to bring in uniformity in the characteristics of similar type of schemes launched by different fund houses. This was to help investors to evaluate the different options available before taking an informed decision to invest in a mutual fund.

After the categorisation of mutual funds, large-cap funds had to invest a minimum of 80% of their portfolio in the top 100 stocks as calculated based on the market capitalisation of the stocks. Due to this, large cap funds are struggling to beat the benchmark index that is available at a lower cost. Note that before the recategorisation, several large-cap funds could take exposure to mid- and small-cap stocks and this helped them generate higher returns. 

Now, what are the differences between index funds and large cap funds?

Large cap funds are actively managed funds. Funds where the fund manager decides which companies to invest in based on their research are called actively managed funds. All large/mid/small cap funds are actively managed funds. 

Index funds are passively managed funds. Funds that track or mimic the composition of an index are passively managed funds. The index could be Nifty 50, Nifty Midcap 100, BSE Small cap, etc. For example, an Index fund tracking Nifty 50 will invest in all the 50 companies on the Nifty. 

So, in a large cap fund, the fund manager decides which stock or sector to invest in. An index fund just tracks the benchmark index. There is no market research or intelligence involved here. 

Since market research skills are needed for large cap funds, these funds have higher expense ratio compared to index funds. The biggest advantage of an index fund over a large-cap fund is its low cost. Fund management cost of an index fund can be as low as 0.17% whereas large cap funds charge anywhere between 1.5% to 2.25% as fund management charges.

Then, come the fund performance. Note that if the large cap fund managerís views are right, the fund will generate higher returns or will outperform the benchmark. However, if the views donít turn out to be right, it can lead to lower returns or under performance. For index funds, the returns will mimic that of the index.

The volatility of the index funds is generally comparatively lower than that of large-cap funds.

Who should invest in large cap funds?

Investors with a low level of risk tolerance can consider large cap funds. Investors who belong to the elderly age group or those who are nearing retirement should consider adding large cap funds to their portfolio. Even those who are looking at income can consider large cap funds with a good dividend history. The steady flow of dividend acts as a stable source of income. Investors with a long investment horizon and looking to invest for long term goals could channel their investments towards large cap funds. When compared to mid-cap funds and small cap funds, large cap funds are less risky.

Who should choose index funds?

First time mutual fund investors can consider index funds. It is a good way of getting introduced to the market at lower costs and lower risks. Those investors who are nearing their age of retirement could consider Index funds. Investors with low risk profile and limited capital can try index funds. 

Whatís the buzz in the marketplace?

With several large cap fund managers mimicking the benchmark index, wealth managers and other financial experts feel investors can make large cap allocation using low cost index funds. In these, fund managers donít hold on to cash and there is no fund manager bias. 

There are others who are saying that if you are going for an actively managed fund it is best to choose multi cap funds rather than large cap funds. Why? This is because these funds have the flexibility to choose stocks across the large cap, mid cap and small cap categories. So, while risk-averse investors can choose index funds, those with a medium or high-risk appetite could consider focused funds as part of their large cap allocation. If you are not sure about which fund suits your risk profile, financial situation and life goals, get in touch with your consultant at wealthzi.com.

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