Markets are increasingly becoming more dynamic and efficient. In such markets, unless a fund has significant flexibility with regard to its investment universe, it is difficult for a fund to outperform its benchmark. This is particularly true for the large cap category. We discuss below the importance of flexibility for a large cap fund and how the focused large cap fund category has a distinct advantage in this regard.

In line with the worldwide trend, the proliferation of ETFs (exchange traded funds) has been increasing in India. This has heightened investor scrutiny of value added by active funds, measured in the form of “Alpha” (returns earned over and above market after deducting costs).

Unless a fund has investments which are different from the benchmark, it is difficult for a fund to outperform its benchmark.

The ability of a fund to be distinct from its benchmark is highly dependent on the flexibility it enjoys with regard to its investment universe. Hence, funds with high investment flexibility have an advantage.

Active ratio

Typically, even within active funds, there can be two broad categories based on their active ratio. There are funds which have low active ratio (fund weight away from benchmark) and are benchmark hugging, while the other category funds are those with active ratio on the higher side.

Funds in the first bucket is often referred to as closet index funds. A fund with closet index strategy logically will find it difficult to have returns different from its benchmark index.

In our view, for a large cap fund to meaningfully outperform its benchmark index, it needs to have a high active ratio and also be benchmark agnostic.

However, this can only be possible if the fund has a flexible investment universe.

Pros & cons

Both large cap and mid-cap stocks have their own distinct advantages and disadvantages. While the large cap stocks typically provide higher stability and lower volatility, mid-cap stocks include a higher proportion of young high-growth companies and emergence stories.

Historically, the variance range between the large and midcaps have varied significantly across market cycles. Hence, having an ideal mix of large cap and mid-cap stocks can optimise the long-term returns of a fund.

Further, our study based on the index performance of Large cap Nifty 50 index and Midcap 100 index suggest that the ideal mix of large and mid-cap stocks for an investor to optimise his or her risk reward ratio (attain higher shape ratio) is ~74 per cent large cap and 26 per cent midcaps. A focused large cap fund is in a position to achieve this ideal ratio.

In the past, a traditional large cap fund used to have very low flexibility as its investment universe was restricted to the top 100 stocks by market capitalisation.

Reclassification benefit

The Sebi reclassification of investment universe in 2018 changed this and provided large cap funds with some much needed flexibility.

As such, post reclassification, a large cap fund has the flexibility to invest up to 20 per cent of its corpus across market cap, while 80 per cent of its corpus still needs to be invested in the top 100 stocks by market capitalisation.

Compared to this, a focused large cap fund has a lot more flexibility with regard to its investment universe.

A focused large cap fund needs to invest a minimum of 65 per cent in the top 100 stocks and have the flexibility to invest across market capitalisation for the other 35 per cent of the fund.

This flexibility to have a wider investment universe is an advantage that the focused large cap funds can leverage on over the long term.

For instance, in our large cap fund — Motilal Oswal Focused 25 Fund— we have ensured a few things. First, it is a pure active (active ratio of ~58 per cent) and benchmark agnostic fund (no sector limits), Second, it has focused and concentrated holdings (<25 stocks, with top 5 and top 10 stocks accounting for ~42 per cent and 70 per cent weight).

Third, it has higher flexibility with regard to the investment universe (minimum investment in the top 100 stocks by market capitalisation limited to 65 per cent, with a high flexibility to invest across market capitalisation up to 35 per cent).

Consequently, we feel, investors should incorporate the aspect of evaluating how flexible their large cap

fund is, along with the other key parameters, while shortlisting their funds or assessing the ability of a fund to significantly outperform its benchmark.

The writer is fund manager, Motilal Oswal Asset Management Company