Is time ripe for index funds in large caps?

The equity markets have remained in turmoil over the last year-and-half period.

This especially true in the large cap space where the outperformance of large cap funds over the benchmark has not been significant and in many cases mutual funds of this category have underperformed the benchmark.

There is also sounding of opting for passive funds which have more semblance with that of the benchmark.

Of course, there are many reasons to the lag in the performance. The recategorization of mutual funds by Sebi (Securities Exchange Board of India) has been an important factor.

This has mandated the funds to remain true to their character i.e. fund investment philosophy and not digress thus reducing the confusion for the investors.

In general, most of the large cap funds across the fund houses have larger corpus.

The standardization of approach by the regulator has meant a larger pool of money concentrated of chasing limited ideas in this space and thus lacking in performance.

When the going goes tough, investors look for alternatives and so the passive funds come into the context.

Though, in India, the passive fund category is still negligible (below 5 per cent of the total Assets Under Management, AUM) globally, these funds have taken lion's share in the MF assets, particularly in the US.

This is also because of the low-cost structure of these funds as they have to invest in an index or ETF of the benchmark which reduces the cost of transactions. This reduced cost is an additional gain for the investor in these funds.

Moreover, in the last few quarters, the performance of large cap index has been influenced by heavy weights which have remained buoyant.

The rotation of these stocks within the index has ensured a higher performance while majority of stocks remained underperformed within the index.

As MFs can't concentrate on few stocks due to restriction of the fund allocation within their corpus, would tend to be agnostic to the index and so the underperformance of these funds vis-à-vis the benchmark.

With these scenarios adding up the index funds have begun to make their presence felt even in India.

Though, it could be a natural progression for India to migrate to index funds, the very composition and evolution of indices is still in the nascent stages.

As the markets mature and indices evolve, index funds find more space in the investor's mind and portfolios.

Still long-term performance i.e. over 10-year and above the average active funds have overperformed than the large cap index though increasingly the outperformance is being reduced year after year.

And with a provision for 20 per cent of the fund especially for funds with larger corpus could be allocated to mid-cap stocks, the outperformance could be rubbed back in case of overall better market conditions.

Though expenses and costs are in control of the fund house and could be easily manipulated, the question is innovation in the product mix. The industry must reinvent and bring in product variations so that it helps the investor while sustaining inflows.

This does not make a case against the active management funds for everyone.

No merit is still lost in investing in active large cap funds with consistent long-term performance but needs to be scouted and researched.

And for an investor who cannot avail the help of an advisor or cannot invest time for himself to do the basic research, index funds could be a better alternative.

This is, though not the case with the mid and small-cap funds where better performance is purely upon stock selection.

(The author is co-founder of "Wealocity", a wealth management firm and could be reached at knk@wealocity.com)