Indian Large Cap Mutual Funds: What is their source of outperformance?

In this post, I discuss why it is important for investors to not take mutual fund market cap classifications seriously. In particular, your “large cap fund” is probably either a multi-cap fund all the time or now and then. The notion of what is a giant cap, large cap, mid-cap, small-cap or micro-cap stock is not set in stone. Each analyst has their own definition and it is common to see a fund hop categories.

Unfortunately, mutual fund houses are not bound by any classification rules. They deliberately make the scheme objective as broad as possible so that they have freedom to maneuver and beat the benchmark. How they do so is another matter. This is of course, true in many areas. For example, when I ask my Ph.D. student to define her thesis problem, I will tell her not to be specific as we cannot justify a change later.

The point is that fund houses are perfectly right in doing so. Our problem is that we take rating portals too seriously. They are only good enough as a source of raw data, but we go by their fund classifications and many get swayed by star ratings.

Large cap fund market cap vs last 1Y return

A fund market cap is a measure of the nature of stocks in the portfolio. Higher the large cap stocks, higher the funds market cap. The market cap of “large cap” funds (blue) is plotted against their last 1Y return.

The index funds and etfs are inside the black box. Notice how significantly the market cap of active large cap funds deviates! So they are not truly large cap in that sense! Also, notice how the returns increase as the deviation increases. This is of course because of the returns in the last 1Y in the mid-cap and small-cap segment.

Many index fund fans make a song and dance about this: “outperformance comes only because of investing in other caps”.

Well, I am not too worried about this. The problem lies in placing such a wide variety of investment strategies in the same bin and labelling it as large cap. Yet another reason why star ratings are nonsense.

Large cap fund market cap vs last 3Y volatility

Now I replace the 1Y return with the standard deviation. This is a measure of volatility and is calculated by finding out the deviation from the average of monthly returns taken over the last 3Y.

Notice that higher the deviation from the index fund market cap, higher the volatility. The data point that sticks out (black circle) belongs to fund of fund with an impressive track record: ICICI Prudential Advisor Series — Very Aggressive Plan. Of course, in our obsession with returns and saving tax, we tend to ignore gems like these. It has only a few Crores as AUM. When investors lack logic, why blame mutual funds for chasing “alpha”?!

Large cap fund market cap vs Sortino Ratio (3Y)

Now let me replace the standard deviation with the Sortino ratio. These measures are faulty and technically should be avoided (and therefore star ratings), but I would like to fool around with them for some fast-food analysis. Feel free to ignore.

The Sortino ratio = (fund return — risk free return)/(volatility due to negative returns).

Higher the Sortino ratio, the better.

Active funds do have better Sortino ratios than index funds. In my opinion, this justifies the management fees (of direct plans). Again the fund that sticks out (~ 3.5) is the ICICI fund mentioned above.

The source of large cap fund outperformance may be deviations from the large index market cap. However, the active management does come with more than reasonable risk protection.

What should investors do?

1: Use star rating portals for raw data and not for their opinions.
2: Study scheme documents and understand where the fund can invest and not go by portal classifications.

3: Check if the fund is providing you with downside protection for the fees that they charge. This is more important than returns.

4: Consider funds like Quantum Equity Fund of Funds or ICICI Prudential Advisor Series (it has different plans) as turnkey solutions to beat inflation. So you have to pay a little extra. So what? No one died because they paid more taxes.

5: Recognise that as long investors are immature and seek returns, fund houses will strive to satisfy them by straying more and more from their designated benchmarks*. This is true for both equity and debt funds.

• The designated benchmark itself is an often a farce. They choose benchmarks which are easy to beat.

Unless the regulator defines category bins and unless they insist a minimum overlap with a benchmark at all times, such deviations will continue.

As long as we understand what the fund is doing, such deviation need not be harmful.

How about mid-cap and small -cap funds?

In the mid-cap space, the arrow below denotes the market cap of Motilal Oswal MOSt Shares M100 ETF Fund that tracks the Nifty Free Float Midcap 100. The returns are all over the place. So I am not too motivated to plot the risk stats.

There are not enough small cap funds to say much.

Originally published at freefincal.