Are equal weight index funds getting the better of large cap funds?

5 Jun 2024 , 02:43 PM

ARE INVESTORS LOSING FASCINATION FOR LARGE CAP FUNDS

There was a time when investing in mutual funds for long term growth meant buying into equity large cap funds. Well, equity funds still remain the preferred choice for investors for long term wealth creation, but large caps appear to be losing their fancy. One can argue that the AUM of large cap funds is going up, but that is misleading. For instance, the AUM of mutual funds includes the value of inflows into the fund and also the market value accretion. In a bull market, when the Nifty and Sensex have rallied 20% in a year, large cap funds are bound to gain AUM. But that does not say much about the popularity of these large cap funds among investors. That popularity is captured by net flows into large cap funds, which is disclosed by the AMFI each month.

Month	Large Cap Funds (Net Flows)	Overall Equity Funds (Net Flows)	Share of Large Cap Flows in (Equity Fund Flows)
Apr-24	357.56	18,917.09	1.89%
Mar-24	2,127.79	22,633.15	9.40%
Feb-24	921.14	26,865.78	3.43%
Jan-24	1,287.05	21,780.56	5.91%
Dec-23	-280.94	16,997.09	0.00%
Nov-23	306.70	15,536.42	1.97%
Oct-23	723.81	19,957.17	3.63%
Sep-23	-110.60	14,091.26	0.00%
Aug-23	-348.98	20,245.26	0.00%
Jul-23	-1,880.00	7,625.96	0.00%
Jun-23	-2,049.61	8,637.49	0.00%
May-23	-1,362.28	3,240.30	0.00%
Apr-23	52.63	9,580.29	0.55%
Overall	-255.73	2,06,107.82

Data Source: AMFI (Figures are ₹ in Crore)

The table above captures the net flows into large cap funds and the net flows into equity funds month-wise for the last 13 months. Here are some key takeaways.

• In 6 out of the last 13 months, the large cap funds have seen net outflows. In fact, if you take the aggregate picture of large cap fund flows, it is cumulatively negative for the last 13 months to the tune of ₹-255.73 Crore.
• Ironically, this comes at a time when equity funds overall have attracted net inflows of ₹2.06 Trillion in these 13 months. Obviously, most of the net inflows in this period was captured by the alpha oriented funds like mid-cap funds, small cap funds, sector funds, thematic funds etc.
• If you look at the share of large cap fund flows as a percentage of overall equity fund flows in the last 13 months, the figure is not relevant in 6 of the negative flow months. They have been mentioned as 0.00%. Even in the other 7 months of positive flows, the average share of large cap funds has been just about 3.83%. That is too low for a fund category that has, for a long time, been the primary driver of equity fund flows.

So, what are the key factors that have led to diminishing interest in large cap funds, as measured by the flows in the last one year?

WHY FLOWS INTO LARGE CAP FUNDS ARE DWINDLING

The numbers are telling. In the last one year, the equity funds have got ₹2.06 Trillion and the active large cap funds have seen negative flows overall. That explains this dichotomy.

• The biggest challenge is the ability to consistently outperform the index. According to successive quarterly studies done by S&P, nearly 80-85% of the funds in any average quarter fail to outperform the index over a longer time frame.
• Investors have a much bigger problem on hand. Firstly, the probability of large cap funds not being able to outperform the indices. Secondly, there is the low probability that the investor will actually select the winning funds and that reduces the chances further.
• Ask any fund manager, and they put the blame largely on a phenomenon called Kurtosis. Here is what it means. Today, if you look at the index like Nifty; much of its returns in the last one year has been driven by stocks like ICICI Bank, SBI, Reliance, Bharti Airtel etc. However, fund managers are constrained on how much of the corpus they can allocate to a single stock and that restrains the performance of large cap funds.
• But the real reason today is that there are alternatives like mid-cap funds, small cap funds and even multi-cap funds that can ensure alpha despite the risk of higher drawdowns. For example, large cap funds have given about 16.15% CAGR returns over last 5 years. In the same period, the CAGR returns of mid-cap funds stand at 24.51%, small caps 27.64%, multi-caps at 22.26% and even large & mid-cap funds at 20.31%.

Above all, investors are getting the feeling that there are alternatives available. In fact, today, the logic for investors appears to be that if you want alpha, then small cap funds, mid-cap funds, and thematic funds are a better choice. There are also middle-of the road opportunities like multi-cap funds and large & mid-cap funds which take slightly higher risk but also deliver higher returns. Above all, the large cap funds are now competing directly with index funds and index ETFs, where is where a lot of passive money is flowing.

HOW INDEX PRODUCTS ARE COMPETING AGAINST LARGE CAP FUNDS?

Since the pandemic, there has been a sharp surge in index products like index funds and index ETFs. Here is why these passive products are competing successfully against large cap funds for a wallet share of mutual fund flows.

• Index funds and index ETFs are pure beta products, where there is no alpha effort at all. The only effort made by the fund manager is to keep tracking error at a low level. Look at it this way. The Sensex has grown from 100 to 75,000 in 44 years, which is close to 16% CAGR returns. If you add the average dividend yield of 1.5%, we are looking at CAGR returns of around 17.5%. That is actually better than what the large cap funds have delivered in the last 5 years.
• The big advantage that investors see in index funds and index ETFs is that there is no risk of fund manager discretion. At the end of the day, giving discretion to the fund manager has its own set of risks as the returns are contingent on the market and also the strategy of the fund manager. In short, the fund manager biases and conditioning come into play when deciding your overall returns. There is no such risk in passive index funds and index ETFs for investors.
• Index funds and ETFs are a lot easier for investors to understand and it can be used as a tool to onboard on to equities. These passive funds are also great products for rebalancing portfolio or even for hedging sectoral risk. Diversification is automatically implied in most of these passive funds, while it has to be achieved consciously in active large cap funds. That is becoming increasingly difficult.
• Above all, there is the issue of costs. For instance, a typical large cap fund may have a cost structure in the range of 2.25% to 2.50% overall (including the GST reimbursement and the small city incentives). In comparison, index funds have a total expense ratio (TER) of around 1.25% while in the case of index ETFs it is still lower at around 0.75%. These costs differences may look small to begin with, but over time, the compounding effect can be substantial.

In the array of passive funds, there is a class of funds known as the equal weight index funds. Let us see what they mean and how they are structured, along with the returns in this category of funds.

EQUAL WEIGHT INDEX FUNDS – WHAT THEY ARE AND HOW THEY PERFORMED?

One of the class of passive funds that is growing in popularity in India is the equal weight index funds. Here is how it works. In the major indices like Nifty and Sensex, the weightage of a stock is based on the free float market cap weight. A company like HDFC Bank, ICICI Bank or Infosys; which has a high market cap and a high public float, automatically gets a higher weight in the Nifty. The problem is that the index fund also becomes subject to the weight bias. One way out is the equal weight index fund. In this case, if you take the Sensex, then each of the 30 stocks will have a 3.33% weight in the equal weight index fund. It is considered to be a better reflector of the overall market performance than the market cap weighted index.

Are these equal weight funds popular in India. Currently, there are only a handful of such equal weighted index funds and index ETFs in India. Here is a quick look at such equal weight index funds / ETFs in India.

Scheme Name	NAV Regular	Return (%) 1 Year	Returns (%) Launch	Daily AUM (₹ in Crore)
ICICI Prudential Nifty50 Equal Weight Index Fund	14.94	35.13	27.20	61.76
HDFC NIFTY 100 Equal Weight Index Fund	15.91	48.87	22.61	192.02
HDFC NIFTY50 Equal Weight Index Fund	16.15	35.53	18.72	1,137.16
Aditya Birla Sun Life Nifty 50 Equal Weight Index Fund	16.45	35.26	18.13	273.83
DSP NIFTY 50 Equal Weight ETF	300.11	36.40	16.54	183.79
DSP Nifty 50 Equal Weight Index Fund	23.41	35.45	13.72	1,408.53
Sundaram Nifty 100 Equal Weight Fund	169.80	47.95	12.06	79.07

Data Source: AMFI

What are the key takeaways from the above table on equal weight index funds in India?

• The equal weight index funds and index ETFs have generated average returns of 39.23% over a 1-year period and average CAGR returns of 18.43% if you look at returns since launch.
• What about the maximum and minimum returns. Over a 1-year period, the maximum returns are 48.87% and the minimum returns in this class are 35.13%. That is fairly high consistency of returns. Since launch, the maximum returns are 27.20% and the minimum  returns in this class are 12.06%. Consistency reduces over longer time horizons, although it could more due to the relative recency of these funds.
• How about the alpha factor, i.e. average returns divided by the range of returns. It is 2.8547 over a 1 year period and just 1.217 since launch.

Having understood the performance of equal weight funds, let us turn to a quick review of  large cap funds, to see if this can emerge as an alternative?

HOW LARGE CAP FUNDS PERFORMED OVER DIFFERENT TIME FRAMES?

The table below captures the returns on large cap funds across 1-year period and since launch. Here are the top 10 large cap funds by returns since launch.

Scheme Name	NAV Regular	Return (%) 1 Year	Returns (%) Launch	Daily AUM (₹ in Crore)
Quant Large Cap Fund	15.23	53.48	25.96	1,164.97
WhiteOak Capital Large Cap Fund	13.39	35.12	21.38	500.63
Sundaram Large Cap Fund	20.14	28.52	21.17	3,376.64
Tata Large Cap Fund	484.30	36.17	19.58	2,149.56
Aditya Birla Sun Life Frontline Equity Fund	480.56	32.04	19.46	27,274.78
HDFC Top 100 Fund	1,087.11	37.57	19.28	33,488.50
DSP Top 100 Equity Fund	416.17	34.26	19.18	3,716.97
HSBC Large Cap Fund	445.60	33.33	19.17	1,778.87
Kotak Bluechip Fund	527.03	32.54	18.25	8,467.55
ITI Large Cap Fund	17.71	41.02	18.04	308.51

Data Source: AMFI

What are the key takeaways from the above table on large cap funds in India?

• The active large cap funds have generated average returns of 34.19% over a 1-year period and average CAGR returns of 13.65% if you look at returns since launch.
• What about the maximum and minimum returns. Over a 1-year period, the maximum returns on a large cap fund were 48.77% and the minimum returns in this class are 22.16%. That is fairly low consistency of returns. Since launch, the maximum returns are 17.53% and the minimum  returns in this class are 6.34%. Consistency reduces over longer time horizons substantially compared to the 1-year period.
• How about the alpha factor, i.e. average returns divided by the range of returns. It is 1.2848 over a 1 year period and just 1.2192 since launch.

Having now seen the performance of active large cap funds, let us make a quick comparison of large cap funds with equal weight index funds.

DID EQUAL WEIGHT FUND DO BETTER THAN LARGE CAP FUNDS?

Let us compare these two categories of funds on different parameters.

Parameter	Equal Weight Funds	Large Cap Funds
1-Year Average Returns	39.23%	34.19
Launch Average Returns	18.43%	13.65
1-Year Alpha Factor	2.8547	1.2848
Launch Alpha Factor	1.2170	1.2192

A quick look at the above table will tell you that equal weight index funds have clearly outperformed the large cap funds on 1-year returns, launch returns and the 1-year alpha factor. However, both are at par on the launch alpha factor.

One can argue that this could come from the lower AUM of equal weight funds and the lower costs. But, it is an advantage nevertheless. The moral of the story is that if the equal weight index funds and index ETFs are nurtured, they can pose a potent alternative to the large cap funds in India.