Can index MFs replace large cap MFs?

If we look at the average AUM (Assets Under Management) for the October to December 2018 quarter, the average AUM of index funds stood at Rs. 38.35 billion (includes all types of plans and options) and of large-cap funds was Rs. 178.71 billion (includes all types of plans and options) which is substantially more than index funds. The reason behind the same is that large-cap have a margin to earn additional alpha over the benchmark. Whereas, in case of index funds they follow the benchmark.

Let us now look at the average returns generated by index funds and large-caps in the period of 1-year, 3-year and 5-year. In 1-year, 3-year and 5-year, large-cap funds generated returns of 3.39 per cent, 12.15 per cent and 12.12 per cent, respectively and index funds on the other hand gave 6.52 per cent, 14.09 per cent and 11.68 per cent, respectively. So, if we look at the short-term average returns of 1-year and 3-year, then clearly the index funds have been ahead. However, if we look at the 5-year average returns, then large-cap funds went ahead with a slight margin.

So, should you replace your large-cap funds with index funds? Let us reframe this question as who should invest in index funds and who should invest in large-cap funds? The person who is a conservative risk taker should opt for index funds and if they hold large-cap funds then they may opt to replace it with index funds or may go with 30 per cent large-cap funds and 70 per cent index funds approach. However, moderate and aggressive risk takers must continue investing in large-cap funds, but at if all they wish to invest in index funds then it must not be more than 10 per cent of your large-cap portfolio.