Is it the right time to move from active large-cap funds to index funds/ETFs?

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In recent years, there has been a noticeable shift from actively managed funds to passive funds, i.e. Index funds or ETFs in India. Many reasons can be attributed to this shift. Lower costs involved with passive funds, the underperformance of actively managed funds, and increased awareness of passive funds are some of them.

What do the statistics tell us about active fund performance?

As per the findings of the latest S&P Indices Versus Active (SPIVA) India scorecard report, most of the actively managed funds in India underperformed their respective benchmarks over longer horizons. As much as 86.2% of Indian equity large-cap funds underperformed their respective benchmarks for the one year ending June 2021. The report also discloses that nearly 82.7% of active large-cap funds underperformed their benchmarks over a five-year horizon.

The first half of 2020 saw the S&P BSE 100 index deliver a 3-year CAGR of 3.13%, 5-year CAGR of 5.6%, and 10-year CAGR of 8.13%. Whereas the comparative performance of large-cap funds for similar periods was 1.31%, 4.63%, and 7.98%

How are index funds and large-cap funds different from each other?

Both active large-cap funds and passive funds have their benefits, but it may be the right time to evaluate whether the investments within your portfolio are catering to your financial goals effectively.

Actively managed large-cap funds look at active stock picking to generate superior returns. But in the process, they can be subject to fund manager bias. While in contrast, index funds are not subject to such risks as they just mirror a chosen index. As there is no active fund management involved in passive funds, the fund management expenses are much lower. For instance, the average expense ratio of large-cap funds stands at 2.% while that of index funds is at 0.15%.

Choosing between large-cap and index funds

Investors should take an informed decision about investing in large-cap funds or index funds.

Some of the factors that could help in choosing between active large-cap funds and index funds are

Control over investments: Passive funds just aim at mirroring the index and hence will not allow you to pick funds that invest in particular themes/stocks that find favour with you which may be possible with an actively managed fund.

Cost: Passive funds come with a huge cost advantage as their expense ratios are much lower due to the passive nature of fund management. Lower costs can make a significant difference to your portfolio value over the long term.

Transparency in investments: Index funds or ETFs mirror the index, hence investments in these funds are transparent and easy to understand which might not be the case with an actively managed fund.

Diversification benefits: A well-diversified portfolio can weather market ups and downs. An index like the Sensex or the Nifty 50 is made up of stocks from different well-performing sectors of the economy, thereby offering you diversification. This may or may not be possible with an actively managed fund.

When is the right time to switch from large-cap funds to index funds?

The right time to switch from active large-cap funds to index funds or ETFs is when the former no longer meets your financial goals or shows underperformance. For some investors, switching to passive funds makes sense, as the expenses associated with active mutual funds can easily eat up a substantial chunk of returns. As seen earlier, a majority of the actively managed funds ended up underperforming the index, so it might make little sense to spend on the expense ratio.

Other costs will have to be considered before switching from large-cap funds to index funds. The two major costs that will have to be considered while switching between any two funds are exit loads and taxation.

Exit loads are a percentage of mutual fund NAV that is levied on mutual funds when an investor redeems the investment before a certain pre-decided period (mostly one year for equity funds).

The second important factor is the applicability of taxation. Large-cap funds are equity-oriented funds. Hence, if the holding period is less than one year, the gains on the fund are taxable as Short Term Capital gains at 15% (plus applicable cess and surcharge) and for periods beyond 12 months, the gains are considered as long-term capital gains and are taxable at 10% (plus applicable cess and surcharge) with no indexation benefit (beyond Rs. 1 lakh annual exemption limit on all equities).

Passive funds may make sense, but you should base the decision to switch to index funds on careful evaluation of the existing fund performance and other costs involved with the switch. However, if you are looking to start a new investment, index funds and ETFs can make a worthwhile investment for longer-term horizons.

 

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