Should you shift from active large-cap funds to index funds?

There has been a big debate over the last few years on whether an individual should invest in active mutual fund schemes or passive mutual fund schemes (index funds and ETFs). With time, markets have become more efficient, and it is becoming increasingly difficult for fund managers of active mutual fund schemes to beat the benchmark. This article will look at some performance data and explore whether you should shift from active large-cap mutual funds to index funds?

Generation of alpha

Alpha is the additional return that an active mutual fund scheme has generated as compared to its benchmark. For example, if an active large-cap mutual fund scheme has generated a return of 10% compared to a benchmark’s 8% return, then the active large-cap fund has generated a 2% alpha.

In the last couple of years, very few active large-cap mutual fund schemes have been able to generate any meaningful alpha as compared to the Nifty 50 Index, BSE Sensex 30 Index, or the Nifty 100 Index.
CRISIL analysed the historical performance of actively managed mutual fund schemes. They analysed the 5-year rolling returns of various mutual fund categories across market cycles. Following were the results.

Note: The performance of large-cap mutual funds has been compared with Nifty 50 TRI, mid-cap mutual funds with Mid-cap 100 TRI, and small-cap mutual funds with Nifty Small-cap 100 TRI.

As seen in the above charts, the five-year rolling average alpha of active large-cap mutual funds was high at around 10% during 2006. Since then it started slipping and came down to almost 0% in 2009. From 2009 to 2018, the five-year rolling average alpha was less than 5%. After that, it has slipped into negative territory, which means the active large-cap funds underperformed the Nifty 50 TRI.

In the last few years, many active large-cap mutual funds have underperformed compared to their benchmark as these funds did not have the same exposure to good performers like Reliance Industries, HDFC Bank, TCS, HDFC, etc. compared to their weightage in the Nifty 50 Index.

As seen in the above chart, in the last one year, the five-year rolling average alpha of even active mid-cap mutual funds is hardly anything to talk about. The five-year rolling average alpha of active small-cap mutual funds is still better even though the percentage of alpha generated has decreased over time.

Performance of large-cap funds as compared to Nifty 50 TRI

The CRISIL study compared the absolute number and percentage of active large-cap mutual fund schemes that outperformed/underperformed the Nifty 50 TRI Index. Following were the results.

Analysis of the above chart:

1. During the years 2005-10, a majority (60 – 100%) of the active large-cap mutual fund schemes outperformed the Nifty 50 TRI. 
2. In 2011, the number of active large-cap mutual funds outperforming the Nifty 50 TRI fell to around 40%. 
3. But, from 2012, the active large-cap mutual fund schemes started outperforming once again. With every passing year (2012-2018), the percentage of large-cap active mutual fund schemes outperforming the Nifty 50 TRI went on increasing.
4. In 2018, almost all of the active large-cap mutual fund schemes outperformed the Nifty 50 TRI. 
5. Since then, from 2019 to 2021, the number of active large-cap mutual fund schemes outperforming the Nifty 50 TRI started falling drastically. 
6. In 2021, nearly 90% of the active large-cap mutual fund schemes underperformed the Nifty 50 TRI. As seen in the earlier section, they have generated negative alpha in the latest five-year rolling period ended March 2021.

If this underperformance of active large-cap funds continues in the future also, then there is a case to shift from active large-cap funds to index funds with the Nifty 50 or Nifty 100 as the benchmark. 

Performance of index funds

If an investor decides to consider index funds for investment, they can invest in index mutual fund schemes with indices such as Sensex 30, Nifty 50, or Nifty 100 as the benchmark. Let us now look at the performance of index funds with these indices as benchmarks.

(Source: www.moneycontrol.com)
Note: The above returns are as of 30^th August 2021. The returns are for direct plans with growth options. The one-year returns are absolute. The three and five-year returns are CAGR. The funds have been ranked based on five-year returns.

Invest in index funds with the Glide Invest App

In the above sections, we have discussed how active large-cap funds are finding it difficult to generate alpha over their benchmark. If you are considering investing in index funds, you can partner with the Glide Invest App. Based on your risk profile, your asset allocation will be decided, and you will get the recommendations for the appropriate index funds and other mutual fund schemes. You will get advice on how to plan and systematically invest towards your financial goals. 

With Glide Invest, you will get guidance for:

1. A personalised risk profile assessment
2. Identifying your financial goals
3. Appropriate asset allocation
4. Making a financial plan for each goal
5. Automating the financial plan
6. Review and analysis of your financial plan 
7. Hand holding you till your financial goals are achieved

To start investing towards your financial goals, download the Glide Invest App from Google Play Store or Apple App Store and get started.