There are various studies and comparisons that are undertaken at regular intervals about the performance of various mutual fund schemes and how they are doing as compared with their benchmarks and peers.
One of the most prominent areas that have been under the scanner concerns large-cap funds. Various data have been seen, which shows how a significant part of the active large-cap space has underperformed over different periods of time. These studies then ignite the debate about whether an investor should choose active funds or stay with passive funds. In the midst of this, what is important is to understand the reasons that cause such a situation and here are some of them.
Select Stocks Driving Indices
There are occasions when it is just a few stocks that are driving the rally in the main indices. It could either be stocks of one group or conglomerate or it could be stocks that have a higher weightage in the index, but this has a major impact on the performance of the funds. This is because if any fund does not have these specific stocks in their portfolio, then the chances of underperformance rise very significantly. This is even more true when the rise in these stocks has been huge as they end up contributing a significant part to the overall rise in the index and this can be difficult for the fund manager to cover up from the other holdings.
Sector-Specific Impact
There are times when a particular sector is driving a big rally in the markets or even the reverse is present, which is that a particular sector is not doing too well.
In these cases, having an exposure to the sector in a larger proportion when it is not doing well will lead to a poor show. Not having a higher exposure will mean that if there is a big rally in this area, then the higher returns are missed out. Both of these situations can play out over a period of time, and while the overall performance might be strong, it can make an impact on whether the fund manager is able to beat the benchmark index or not.
Total Returns Index And Expense Ratios
The benchmarks that are used for comparison for various funds are the Total Return Index figures. This includes both the dividends as well as the rise in the value of the components.
The expense ratio in an actively managed fund can also push the scheme below the benchmark returns. The manner in which the expenses are adjusted is that they are reduced from the Net Asset Value of the fund. The expense ratios can be even more than 2% in many cases and this can prove to be a tipping point because even if the fund is able to show some returns that are above the benchmark, the expense ratio can bring the net figure down below the benchmark returns.
Slow Performance Across Different Market Caps
A large-cap fund has most of its assets into large-cap stocks, which are the top 100 stocks in the market as calculated by the market capitalisation of the companies.
There is a small leeway available to these funds to have some small exposure to mid-cap stocks in the portfolio. Fund managers often make use of this small limit and ensure that there is some extra returns for the fund.
However, this is a double-edged sword because it is not that the mid caps will perform well the whole time and that there will be additional returns for the fund.
If the mid caps are doing worse than the large caps, then this can make the situation worse because the overall returns will be worse than what it would have normally been.
Portfolio Construction And Benchmarks
The manner in which the portfolio is constructed by the fund manager and the extent of the portfolio that tracks the benchmark are important factors at play.
Being too closely aligned with the benchmark will reduce the chance of doing better while going too far away from the benchmark can result in an outperformance.
However, if things do not work out, then there will be a huge difference as compared with the other schemes as well and this can be glaring. This is why having a proper balance on this front is essential for the fund manager.
Arnav Pandya is founder of Moneyeduschool.
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