How Index funds differ from the traditional large-cap fund? Why it makes more sense now after the new SEBI guidelines to invest in an index fund over a large-cap fund?
What is an Index Fund?
An index fund is a type of mutual fund where the portfolio of stocks is constructed to match the benchmark index at the same weightage as in the underlying index.
So if we consider a Nifty Index fund, Nifty is constituted of 50 stocks with a weightage of each stock as per the Nifty Index composition guideline. The Index fund will have the exact same stocks with the same weightage of each stock in the fund as in the Nifty.
Let us understand this with an HDFC Fund house as an example. The Nifty Index fund by is “HDFC Index Fund Nifty 50”
How a Nifty Index Fund Differs from a Large Cap Fund?
Actually, there is no similarity.
As per the new 2017 SEBI guidelines, the large stocks are those which are above a certain threshold level of market capitalization. So a large-cap fund has to have 80% of their portfolio allocated to these stocks only. The 20% of allocation can be in either in cash levels or other stocks.
| Large-Cap Fund | Nifty Index Fund |
|---|---|
| A large-cap fund invests in large-cap stocks as per the guidelines of the large-cap stock. | An Index fund, the allocation is in the stocks that are part of the underlying index. |
| The portfolio allocation to each stock in a large-cap fund is at the sole discretion of the fund manager. Can have more allocation to stock or sector where fund house is more bullish and have less allocation to sectors where fund house is bearish. | In an Index fund, the allocation to each stock is as per the weightage of the stock in the index. |
| The large-cap fund, the choice of investment and the allocation is based on the fund manager. | An index fund is independent of the fund manager as there is no stock selection or allocation process. |
| A large-cap fund is free to hold the stock as long as the stock is a large-cap stock. | As and when companies move out of the Index, the index fund also moves out of its investment and move to the one that is included in the index. |
| A large-cap fund can invest in a company which isn’t part of the Index but is part of the large-cap stock basket. As an example, a company moving from a midcap to a large-cap due to an increase in market cap can be invested by a large-cap fund. | An Index fund can only invest in the company that is part of the Index and not prior to that. |
| A large-cap fund still has a room of investing 20% of its asset in the midcap or even small-cap companies to boost the performance of the fund and beat the underlying index. | An Index fund can only invest in a company that is part of the Index. |
I hope it helps to understand the difference between a large-cap fund and an Index fund.
How Index Funds Differ from ETFs?
Index funds and ETFs both mimic the underlying indices but ETFs or exchange-traded funds are more like stocks than like a fund.
ETF’s are traded like a stock day in and day out on the exchange whereas the index fund is like a mutual fund and aren’t traded on the exchange.
Reasons Why You Should Choose a Nifty Index Funds Over a Large Cap Fund in 2019
Pre-2017 there weren’t very clear SEBI guidelines on what is a large-cap stock, a midcap stock or a small-cap stock. The fund had the flexibility of defining their own basket of stocks termed as large mid or small cap. So the performance of mutual funds was easily beating the underlying index.
In 2018, all the funds have re-aligned themselves as per the SEBI’s guidelines.
2019 Onwards, many large-cap funds will find it tough to beat the underlying index by a big margin that they were used to.
So let me share why Index funds make more sense than a large-cap fund for an investor.
Less Expense Ratio
The index funds don’t have to pay any fund manager a salary. So it will always have an expense ratio that is much smaller than the mutual fund.
So if we take the example of HDFC fund house and consider the HDFC Nifty Index Fund and compare that with the HDFC Top 100 fund which is its large-cap fund from the HDFC Fund house the expense ratio as per ValueResearchOnline as on 30Nov2018 of Nifty Index fund is 0.3% of the total asset under management and that of HDFC Top 100 Regular fund is 2.14%. Even for the direct fund, the expense ratio is 1.44% and the direct Index fund has an expense ratio of only 0.1%.
Clearly, Index funds have an advantage over the large-cap fund.
The time will tell if the large-cap fund can justify it’s higher expense ratio or not but as of now in 2019, it seems more logical to consider an Index fund over a large-cap fund.
Higher Outperformance Seems Tough
An earlier fund manager could invest some portion of the money into stocks that weren’t considered purely large-cap because there were no clear guidelines.
Some fund houses defined their own limit of large-cap stocks as largest 100 companies where others defined large-cap as 200 largest companies.
Now when SEBI has defined the market capitalization guidelines and asked fund to have 80% allocation of the fund into their respective market cap stocks only.
Going forward, the performance of the fund will replicate more with the benchmark and depending on the house view of sector underperformance and outperformance will decide the returns from the fund.
The only way a large-cap fund can now beat the index is by going underweight or overweight its weightage for sectors. Getting it wrong can mean an underperformance of the fund to a large extent. The time will tell how the fund house performs but as of now it is better to be going with the Index funds.
A couple of years down the line and there will be a clear separation of men from the boys.
More Control over Asset Allocation
As an investor, when you invest in an Index fund, you know which are the companies you are investing in.
An investor has more control over his asset allocation. The control over where they want to invest instead of letting the fund manager take the call.
If an investor isn’t sure, there is always an option of either a Multicap fund or a Balanced Fund but purely for a large, mid and, small-cap fund now investor has a clear picture of his asset being allocated.
Less Volatile
Index funds are not an actively managed and is more of a passive management. So the volatility and the turnover ratio of an index fund is typically lower than large-cap funds.
Conclusion
It has been less than a year or so since the SEBI’s guidelines have been implemented by funds. So we can’t compare a large-cap fund’s return with the index fund as yet to have any conclusion.
Still, it seems quite logical based on the expense ratio itself that it makes lot more sense to invest in an Index fund in 2019.
What are your views on Index funds? Share them in the comments below.
Hi Shabbir,
“A couple of years down the line and there will be a clear separation of men from the boys.”
So.. do you still hold the same opinion that Index funds are better after 2 years in 2022? Please suggest if you have observed any difference.
Appreciate your response.
Thanks
Yes I do. Let’s look at some numbers.
In May 2020, Nifty was around 9k. Today it is around 17k+. roughly double. So in 2 years the return in Nifty has been around ~25%. We are ball parking for faster calculation.
Now, lets look at all large cap funds in ValueResearchOnline here.
More than 70% of the large cap funds are not able to generate that returns.
thank you.
Which is Mid and Small cap index fund and ETF?
Is there any etf or index fund with a mixture of Large+mid cap like Mutual funds?
which is the best Index fund according to you for 2019. I am not sure between HDFC and UTI? are there only two index funds ? ICICI next 50 has the highest returns over 5 years
The return of index funds should be same as index. Go with the one that has least expense ratio. Atleast that is what Warren Buffet looks in an index fund.
Nice Article Shabbir…
What will be your suggestion on Index Funds? which fund house will you suggest to invest.
I will say pick the one with the least expense ratio because the returns are all same as the underlying index.
Very nicely explained, index funds and etf are similar, etf has even lesser fees right?
Nope. They have a fees as much as your broker charges.
Very informative Shabbir!! I have a doubt – which option is better to invest in nifty index? ETF or MF?
Nifty Index fund over a large cap fund. ETF and Index fund are different but for a passive investor, Index fund is much better choice.
I think the most important difference is that Large Cap funds performance is driven by the Fund Manager whereas in the Index fund, the manager does not matter. Star managers will shift AMCs, based on offers made, and that may not be tracked by the small investor. This will impact the returns from the Large Cap fund without their knowledge. In the Index fund, the stock churn happens depending on the Index and hence the fund manager is not consequential
Very true.
Thank you very much for giving such a detailed overview of the difference between large cap MF and Index Funds.
The pleasure is all mine.
what about nifty next 50 index fund, do u suggest it as well.?
Depends if you are investing in a mutual fund benchmarked at next 50 then yes. If both an index fund and a mutual fund have the same benchmark, index funds will win. If mutual fund has an option to choose more stocks, the odd of beating the benchmark increases considerably.