Large Cap Funds VS Index Funds VS ETFs

There is a difference between the performance of actively managed large-cap funds, index funds and ETFs, despite these fund categories investing in similar stocks. DSIJ explains how large-cap funds, index funds and ETFs fairs when compared with each other and the reason for the difference in their performance.



The year 2018 was not a good year for the stocks and this has been even extended to mutual fund schemes' performance too. Although, among all equity mutual funds, the large-cap funds were the one that fell less, but they still gave negative returns on an average. There were only eight funds that generated positive returns out of a total 38 funds. During the same period, the index funds and ETFs (Exchange Traded Funds) on an average gave positive returns, thereby mimicking their benchmarks. The index funds and ETFs gained a lot of traction from the investors. This may prompt many investors to exit from large-cap funds and enter into index funds and ETFs. Is it advisable to do so? Let's find out.

Despite all the above products following the same benchmarks or indices, they are showing divergence in their performance. To understand which is better, it is important to understand the product itself. So, let us first understand the difference between the large-cap funds, which are actively managed funds, alongside index funds and ETFs, which are passively managed funds.

Actively managed funds


Actively managed funds are those where you have a fund manager and he decides which companies should form part of the fund's portfolio and what should be the weightage of the stocks in the portfolio. The selection is done based on his understanding of the market and his style of analysing stocks. Any fund which does not imitate holdings of the index or benchmark in the same proportion can be termed as actively managed funds. Then may it be large-cap, mid-cap or smallcap funds or even sectoral funds, all are actively managed funds.

Passively managed funds

Passively managed funds, as the name suggests, are passive in nature. The main job of passively managed funds is to track the benchmark. These funds can follow different indices, may it be Nifty 50 or Sensex or BSE 100 or BSE 500 or any such index. Here the portfolio of the fund must constitute the same stocks and in the same proportion as the index it is tracking. Index mutual funds and ETFs are the best examples of passively managed funds.

As we have understood the difference between actively managed and passively managed funds, let us individually understand what do large-cap funds, index funds and ETFs do to get a lot more clarity.

Large-Cap Mutual Funds

Large-cap mutual funds are those that invest majorly in companies having higher market cap. As per the SEBI (Securities and Exchange Board of India) circular on recategorisation, large-cap funds are those that invest minimum 80 per cent of the assets into equity and equityrelated instruments of large-cap companies. SEBI has also defined large-cap companies as ranking from the 1st to 100th in terms of full market capitalisation. So, a large-cap mutual funds invests minimum 80 per cent of its assets in the top 100 companies in terms of full market cap. However, it is free to invest the remaining 20 per cent of its assets as desired.

Index Mutual Funds

Index mutual funds are those that invest a majority of their assets in stocks that constitute the benchmark it is tracking and in the same proportion. SEBI defines index funds as those that invest minimum 95 per cent of the total assets in the securities constituting the particular index that the fund tracks.

ETFs

ETFs are similar to index mutual funds where they invest a majority of the assets in the stocks that constitute the benchmark that is being tracked and in same proportion as the index. SEBI defines ETFs as the same as index funds. This in no sense means that they are the same. Though their approach is similar, they differ in structure and costs in terms of expense ratio. ETFs are traded on the exchanges just like shares, whereas index funds work similar to other mutual funds which collect money from the investors and invest it. This makes ETFs cheaper in terms of expense ratio than the index funds.



AUM

As far as AUM is concerned, for the month of April 2019, the AUMs of the large-cap funds stood at Rs 1,261.33 crore, whereas, in the same month, the AUMs of index funds and ETFs stood at Rs 52.25 crore and Rs 1,325.91 crore, respectively. So, in terms of AUMs, ETFs have the highest assets under management. The reason for higher AUMs for ETFs is because there are also ETFs that do not track large cap indices and invest beyond top 100 companies by market cap. You will notice that the index funds have the lowest AUMs as compared to the ETFs and large-cap funds. The reason for the same seem to be that most of the mutual fund distributors and intermediaries do not progressively promote index funds. This is because the commissions they receive is less than what they receive by promoting or selling large-cap funds.



Let us now understand how do these fare in terms of returns. To do so, we would plot average annual returns of the past 10 years and see how they have performed. To make it a fair comparison, we have not considered other ETFs and index funds that do not invest in top 100 companies in terms of market capitalisation.



If we look at the average returns generated by these categories of funds, then only in the year 2011, 2014 and 2015 large-cap funds have beaten the returns provided by index funds and ETFs. In the year 2010, 2012, 2016 and 2017, large cap funds were at par with index funds and ETFs. On the other hand, in 7 out of 10 years (2010, 2011, 2012, 2014, 2015, 2016 and 2017) index funds were at par with ETFs. For the rest of the period, ETFs have beaten the index funds.

Now, if we look at the returns provided by the ETFs, then out of 10 years, ETFs have scored for 3 years over the large-cap funds and index funds. So, in terms of returns, ETFs and large-cap funds have proven to be better than index funds. Now if we take a look at the risk aspect, since ETFs and index funds track the index itself, the risk as measured by beta would be near to 1. The average beta of ETFs and index funds is 0.96 and 1, respectively. On the contrary, since large-cap funds are actively managed, the fund manager has a room to manage risk as well, so there is a probability of having beta less than 1. Large-cap funds have average beta of 0.92. In terms of alpha generated by these categories in the last one year, ETFs score over large-cap funds and index funds with average alpha of -1.26 compared to -4.87 and -1.93 for large cap funds and index funds, respectively.

Costs involved

Even in terms of costs, ETFs score over the index funds and large-cap funds with an average expense ratio of 0.15 per cent, while the index fund and large-cap funds' expense ratio being 0.31 per cent and 1.13 per cent, respectively. However, as the ETFs are traded on the exchanges, you need to have a demat and trading account with a broker and for every trade, you need to incur brokerage charges per transaction like shares. But usually you will not be involved in active trading of ETFs, so the overall brokerage cost will not affect you. For ETFs, you have to maintain a demat and trading account for which you are required to pay annual maintenance charges. The average brokerage cost per transaction is around 0.4 per cent and you would be only paying while buying once and while selling once. In between, apart from the expense ratio, you would only be incurring the annual maintenance charges, which in the industry is around Rs 500 per year.

Conclusion

So, we can see that ETFs have been generating better returns than large-cap and index funds. Even in terms of cost, ETFs are cheaper that large-cap and index funds. The low expense ratio allows ETFs to generate alpha higher than the large cap and index funds. Overall, ETFs prove to be the better investment option than large-cap and index funds. Though index funds are at par with ETFs in many cases, they carry the probability of higher tracking error when compared to ETFs. ETFs are structured in such a way that tracking error is minimal.

However, one thing to note is that India is still an emerging economy having lot of opportunities to grow further and this gives active fund managers the scope to generate alpha over benchmarks, which is not the case with plain vanilla ETFs and index funds. Now the question is, where to invest? If you are a moderately conservative to moderately aggressive risk taker, then you should go with large-cap funds. However, if you are a conservative risk taker, then you would be better off investing in ETFs and index funds. However, having a financial plan in place is always beneficial as it helps you to gauge your overall financial situation, life's goals, risk appetite and helps you to invest in a disciplined way.

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