Factors to consider when deciding your large-cap fund

Large-cap Funds form the core of the mutual fund portfolio for investors as they provide stability and growth potential to the portfolio. However, choosing the right large-cap fund requires careful analysis and consideration because creating Alpha has become a challenge for many large-cap funds. Hence, enough diligence should be done to help you make an informed decision when selecting a large-cap fund.

Overlapping Holdings: Analyzing Diversification

When evaluating large-cap funds, examining the level of overlapping holdings is crucial. A dataset prepared on the top 10 largest Large-cap funds based on AUM suggests that 73% of large-cap funds have a significant 40-60% overlap in their holdings. Furthermore,24% of Large-cap schemes have more than 60% of the same holdings. While some overlap is expected due to the nature of the large-cap universe, excessive overlap can sabotage diversification benefits. Investing in multiple funds with high overlapping holdings may expose your portfolio to unnecessary concentration risk and doesn’t add anything to Alpha.

Consider funds that exhibit complementary holdings, provide unique exposures, and potentially add value through differentiated stock selection. By carefully assessing overlapping holdings, you can build a well-diversified large-cap portfolio that mitigates undue concentration risk.

Active Share in Portfolio: Differentiating Active Management

Active Share measures the degree of differentiation between a mutual fund’s portfolio and its benchmark index. Low Active Share suggests the fund closely mirrors the index, resembling a passive fund. In such cases, investing in a passive fund directly tracking the index may be more cost-effective, as it typically carries lower expense ratios.

When considering large-cap funds, look for those with a higher Active Share. Funds with a higher level of active management have the potential to generate alpha by deviating from the index and selecting undervalued stocks. However, assessing the fund’s historical performance and consistency alongside Active Share is vital to ensure the active management strategy has successfully generated returns.

Expense Ratios: Managing Costs

Expense ratios are a crucial consideration when investing in mutual funds. Larger assets under management (AUM) generally lead to economies of scale, allowing funds to offer lower expense ratios. In the case of large-cap funds, data suggests that first 90% of large-cap schemes based on AUM, have an average expense ratio of 1.7%, while the remaining 10% have an average expense ratio of 2.3%.

While expense ratios should not be the sole determinant, selecting funds with competitive expense ratios is advisable, ensuring that costs do not eat into your investment returns over the long term.

Historical Performance vs. Index & Benchmark

Examining a large-cap fund’s historical performance is essential to gauge its consistency and ability to outperform the benchmark index. Please consider the fund’s track record over different market cycles without ignoring portfolio composition and expense ratios.

Additionally, it is worth considering the impact of small and mid-cap exposure within the large-cap fund’s portfolio, as large-cap funds have leeway to invest up to 20% of their AUM in Mid & Small Caps. Over the past 7-10 years, funds with a higher allocation to small and mid-cap stocks have delivered better returns than large-cap funds in the same category. The accompanying table brings this point out. This highlights the importance of considering the fund’s composition and the potential influence of different market segments on overall performance.

The writer is Co- Founder and Partner at Upwisery Private Wealth

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