Markets are increasingly becoming more dynamic and efficient. In such markets, unless a fund has significant flexibility with regard to its investment universe, it is difficult for a fund to outperform its benchmark. This is particularly true for the large cap category. We discuss below the importance of flexibility for a large cap fund and how the focused large cap fund category has a distinct advantage, in this regard.
In line with the worldwide trend, the proliferation of ETF’s (Exchange Traded Funds) has been increasing in India. This has heightened investor scrutiny of value added by active funds, measured in the form of ‘Alpha’ (returns earned over and above market after deducting costs). Unless a fund has investments, which are different from the benchmark, it is difficult for a fund to outperform its benchmark. The ability of a fund to be distinct from its benchmark is highly dependent on the flexibility it enjoys with regard to its investment universe. Hence, funds with high investment universe flexibility have an advantage.
Typically, even within active funds there can be two broad categories based on their active ratio. There are funds which have low active ratio (fund weight away from benchmark) and are benchmark hugging, while the other category funds with active ratio on the higher side. Funds in the first bucket is often referred to as closet index funds. A fund with closet index strategy, logically will find it difficult to have returns very different to its benchmark index. In our view, for a large cap fund to meaningfully outperform its benchmark index, it needs to have a high active ratio and also be benchmark agnostic. However, this can only be possible if the fund has a flexible investment universe.
Both large cap and mid cap stocks have their own distinct advantages and disadvantages. While the large cap stocks typically provide higher relative stability and lower volatility, mid cap stocks typically have higher proportion of young high growth companies and emergence stories. Historically, the variance range between the large and midcaps have varied significantly across market cycles. Hence, having an ideal mix of large cap and mid cap stocks can optimize long term returns of a fund. Furthermore, our study based on index performance of large cap Nifty 50 Index and Midcap 100 Index, suggest that the ideal mix of large and mid-cap stocks for an investor to optimize their risk reward ratio (attain higher Shape Ratio) is ~74% large cap and 26% midcaps. A focused large cap fund is in a position to achieve this ideal ratio.
In the past, a traditional large cap fund used to have very low flexibility with its investment universe restricted to top 100 stocks by market capitalization. The SEBI reclassification of investment universe in 2018, changed this and provided large cap funds with some much needed flexibility. As such, post reclassification a large cap fund have the flexibility to invest up to 20% of its corpus across market cap, while 80% of its corpus still needs to be invested in top 100 stocks by market capitalization. Compared to this, a focused large cap fund has lot more flexibility with regard to its investment universe. A focused large cap fund needs to invest a minimum of 65% in the top 100 stocks and have flexibility to invest across market capitalization for the other 35% of the fund. This flexibility to have a wider investment universe is an advantage that the focused large cap funds can leverage on over the long term.
In this regard, we believe our large cap fund Motilal Oswal Focused 25 Fund, is one of the most flexible large cap funds and has several unique advantages. Firstly, it is a pure active (active ratio of ~58%) and benchmark agnostic fund (no sector limits), Secondly, it has focused and concentrated holdings (<25 stocks, with top 5 and top 10 stocks accounting for ~42% and 70% weight) and Thirdly, it has higher flexibility with regard to investment universe (minimum investment in Top 100 stocks by market capitalization limited to 65%, with a high flexibility to invest across market capitalization up to 35%).
Consequently, we feel, investors should incorporate the aspect of evaluating how flexible their large cap fund is, along with the other key parameters, while shortlisting their funds or assessing the ability of a fund to significantly outperform its benchmark.
By Mr. Siddharth Bothra, Fund Manager, Motilal Oswal AMC
This article was originally published in The Telegraph on 4th Jan, 2021