How to choose the right largecap mutual fund?

Your choice of largecap funds should be driven by your long term goals and also tagged to it.

Mar 31, 2019 10:03 IST India Infoline News Service

With the Sensex at above 38,000 and the euphoria in full flow, selecting a largecap equity fund can be a tricky task. You need to be systematic in your approach and realistic in your expectations. Here are five points you must consider to select the right largecap fund.
 
Base it on your holding period
 
That, in a way, is the Holy Grail. You are best off in a largecap fund if you have a holding period of above 7 years. That is because largecap funds are normally a mix of financials, cyclicals, commodities and consumer stories. While consumer stories may be less cyclical, the others can go through fairly long cycles. Hence, a largecap fund can either disappoint you or give you a sub-optimal picture if you consider a shorter time period. Of course, you must consider the historic returns of the funds before you select the large cap fund; but there is only so much that past returns can tell you. Once you are convinced about past performance, you need to have the patience to hold these largecap funds for at least 7-8 years to be able to reap the full benefits.
 
Check if it does better than an index fund
 
One of the reasons for the SEBI reclassification of funds in 2018 was that many largecap diversified funds virtually mirrored an index fund. However, there was a vast difference in their expense ratios, to the detriment of the unit holder. One of the basic tests you must apply is to compare the returns with an index fund on a risk-adjusted basis. Here is how!
Fund Details Beta Index Fund Alpha Largecap Fund
Total Investment in the Fund Rs1 lakh Rs1 lakh
Holding Period 7 Years 7 Years
Investment Value after 7 years Rs2.21 lakh Rs2.50 lakhs
CAGR Returns over 7 years 12.00% 14.00%
Beta of the Fund 1.00 1.25
Beta-adjusted Treynor 12.00% 11.25%

When you invest in an index fund, you only take the market risk. That is why it has a Beta of 1. In the above case, the largecap fund has an aggressive portfolio with a beta of 1.25. When you adjust the returns for Beta, you actually find that you would have been better off in an index fund than in the largecap fund. This gives you perspective.
 
Check the expense ratio
 
In a way, this is related to the previous point. The index fund has managed to generate decent returns (even without considering risk) because it has a much lower expense ratio. Even when you compare two largecap equity funds, you must compare on the expense ratio. Typically, the expense ratio of a largecap equity fund ranges from 2.2% to 2.6%.  You may say that 2.5% is the peak but they are allowed additional incentives for selling funds in smaller towns. Essentially, you must choose the largecap fund with a lower expense ratio.
 
Largecap funds can be combined with ELSS
 
This is an interesting idea for investors in largecap funds to consider. When you allocate to largecap funds via ELSS, there is the additional benefit of tax exemption on the investment that you get under Section 80C of the Income Tax Act. Since largecap funds do not give you a great alpha over index funds, you can actually consider your largecap allocation via ELSS to enhance overall returns. The effective post tax yield will enhance the fund yield overall.
 
Does it fit into your goals?
 
When you buy largecap funds, there is a risk element and return element to it. Above all, there is also the liquidity element in the short to medium term. Your choice of largecap funds should be driven by your long term goals and also tagged to it. That is the key to investing in largecap funds.

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