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Large cap ETFs beat actively-managed funds, index funds. What should be your pick?

strategy
Many mutual fund advisors are recommending large cap index schemes to their clients these days. Even some fund managers believe that index schemes are likely to gain popularity in India in the coming months. However, an average investor (or DIY investor) looking closely at the performance chart may be totally confused: most top performers are large cap ETFs, and very few regular large index funds figure among the toppers.

Look at the data. Among the top 25 large cap schemes in the three-year performance chart, only three are actively managed schemes. However, only one index fund figures among the top 25 schemes. Confused? Yes, the remaining 21 schemes are large cap ETFs. ETFs are exchange traded funds that can be bought through a stock exchange.

“The clear pick among ETF and index fund would be index funds for the sheer convenience that it provides to the mutual fund investor. It is a good choice in terms of liquidity and regular investments,” says Suresh Sadagopan, Founder, Ladder7 Financial Advisors.

First, ETFs are not a convenient investment option for retail investors because they need a demat account to invest in ETFs. They also cannot invest through SIPs in ETFs. Second, ETFs are not very liquid. That means investors might have trouble finding a buyer or getting the right price when they want to sell their investments in ETFs. Investors can redeem their investments in index funds like any other mutual fund schemes. However, they must sell their ETFs at the exchanges.

Okay, let us exclude ETFs from the picture and look closely at index funds. In the absence of ETFs, data shows that eight index schemes figure among the top 15 large cap schemes. Look closer, and you will find that these index funds are not exactly mirroring the index. These schemes are returning at least one per cent lower than the benchmark index. Such differences or tracking error is common among index funds, but does it offer an edge to actively-managed schemes?

“While comparing an active and a passive scheme, you have to take into account the price differential. An active fund generally charges 1-2 per cent fees, while the passive scheme charges fees as low as 0.10 per cent. To actually beat the passive funds, active schemes have to generate alpha over and above this 2 per cent,” says S R Srinivasan, Founder, Srinivesh Advisors.

For example, Sundaram Select Focus Fund, one of the top actively-managed large cap scheme in the last three years, charges an expense ratio of around 2.48 per cent on its regular plan (1.69 per cent for direct plan). HDFC Index Fund- Sensex Plan, on the other, charges 0.10 per cent as expense ratio. The expense ratios of the actively managed funds range from 1-2 per cent, compared to 0.10-0.50 per cent charged by index funds.

Does that mean that you should start investing in large cap index funds? “In a narrow rally like we saw recently, only a few big stocks perform. In such times, an active fund manager, if he has the skill, can definitely beat the index,” says Suresh Sadagopan. “However, after TRI, re-categorisation, strict mandates, outperforming the benchmark is going to become more difficult. When the market starts performing and the rallies are broad, the indices will perform better. Beating the index funds by a margin of at least 3 per cent is going to be a task,” adds Sadagopan.

Mutual fund advisors say index funds give investors a chance to focus on the giant or mega cap stocks. “Those investors, who want to bet on the biggest, low risk stocks, can choose Nifty 50 index funds. Those who want to bet on the next 50 can invest in Nifty next 50. This option, the active large cap schemes won’t give you,” says S R Srinivasan. He adds that evolved investors can use these schemes in their portfolio.

Finally, like it or not, index funds are going to gain more currency in the coming days. Gone are the day when large cap schemes used to post impressive returns with the help of mid cap stocks. Re-categorisation exercise has put an end to such practices. “You still have a choice of choosing an active or a passive fund in large caps. We are just saying it is a trend that we should see that investors will get a good scheme at a lower cost and maybe very similar returns,” says Suresh Sadagopan.
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