Index Funds vs. Large Cap Funds

Published On: 24-Apr-2020

When it comes to investing in mutual funds, investors have a wide range of options to invest, like equity funds, debt funds, hybrid funds, solution-oriented schemes, etc. Even within the universe of equity funds, SEBI allows the mutual funds to offer schemes under different categories like large-cap funds, ELSS, small-cap funds, value funds, etc. 

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Being equity funds, the funds must invest at least 65% of their net assets in equity and equity-related securities. Even in the broad category of other funds, index funds may be classified as equity funds, as the criteria to be classified as equity-oriented funds is fulfilled in index funds as well. However, the categories differ in terms of investment mandate, risk profile, etc. This article aims to compare large-cap funds and index funds. 

As per the SEBI guidelines, a large-cap fund must invest at least 80% of its net assets in equity shares and related instruments of large-cap companies. The top 100 companies as per the market capitalisation are classified as large-cap companies. Thus, such companies tend to reflect a proven track record of performance. On the other hand, an index fund tends to replicate a underlying index, and at least 95% of its net assets must be invested in the securities and also in a similar weightage as that of the underlying index it tends to replicate. 

Here is the comparison of these two categories of funds on various investment considerations:

Investment Portfolio

Large-cap funds adopt an active investment strategy, wherein the fund manager may take an investment decision about the sector as well as the stocks in the portfolio, subject to the broader investment mandate to predominantly investing in large-cap companies. 

On the other hand, the fund managers do not enjoy any flexibility to structure the portfolio of the index funds. The investment mandate in such funds is to replicate the composition of the underlying index, and the fund management team only needs to track the changes in the index composition and to implement the same in the fund as well. 

Generation of Alpha 

Since the index funds replicate the composition of the underlying index, the returns generated by such funds will be similar to the returns generated by the underlying index, subject to tracking error and scheme expenses. 

On the other hand, since the fund manager of large-cap funds has the flexibility to choose from the stock basket of the top 100 stocks, such funds may outperform the benchmark indices, thereby generating alpha for the investors. 

As per the data released by the Association of Mutual Funds in India (AMFI) for February 2020 also reflects the investors’ preferences to invest in large-cap funds against index funds, possibly due to the probability of generating alpha in large-cap funds as against index funds. 

As on 29th February 2020, large-cap funds were the 2nd most popular category within the equity funds with 98 lakh investor folios and AUM (Assets Under Management) of Rs. 1.46 lakh crores, as against around 5 lakh investor folios with AUM of Rs. 8000 crores under index funds. 

Data source – AMFI

Unsystematic Risk for the Investors 

The investment risks in mutual funds may be classified as systematic risk and unsystematic risk. While the systematic risk refers to the risk of negative returns due to overall negative sentiment and market correction, the unsystematic risk refers to the probability of loss due to wrong investment decisions by the fund manager. 

Considering the investing strategies adopted by large-cap funds and index funds, the large-cap funds stay exposed to the unsystematic risk. In contrast, the investors may mitigate the unsystematic risk for their investment portfolio with index funds on account of passive investing strategies for such funds. 

Expense Ratio 

As passive investing strategy involves almost negligible fund management discretion, index funds will carry lower fund management charges, and ultimately lower expenses ratios for such funds. Large-cap funds, on the other hand, may have higher expense ratios as compared to index funds. 

Taxation

This is one of the key investment considerations for investors, and ironically, both the categories, large-cap funds, and index funds are subject to similar tax rules. If the holding period of mutual fund units in these funds is less than 12 months, the returns are taxed as Short-Term Capital Gains (STCG) with a tax rate of 15% (plus applicable cess and surcharge). 

The returns on mutual fund investments with a holding period of 12 months or more are classified as Long-Term Capital Gains (LTCG) and taxed at 10% (plus applicable cess and surcharge) without any indexation benefit (post Rs. 1 lakh exemption limit on LTCG from equity shares and equity-oriented funds per year).

With the key investment considerations outlined above, investors may take an informed decision about choosing to invest in large-cap funds or index funds.  

Note: The tax rates as mentioned in the article are for illustrative purposes only and are updated as per the Union Budget 2020 presented by the Govt. on 1st February 2020. The tax rates for capital gains will be as per the tax laws applicable on the date of redemption/ sale and not on the date of investment.