Is investing in index funds the best way to take large-cap exposure?

This seems like a rational thought to have on the face of it.

But there is another aspect of this debate that is missed when proponents of index funds start taking the moral high ground of low-cost.

The major indices that index funds track are the Nifty 50 and Sensex. Now, many stocks have disproportionately high weights in these indices. Take for example the Nifty 50, which is considered a diversified index with 50 stocks. But in reality, the top 3 stocks of Nifty have 32-33 percent weight, while the top 5 account for 44-45 percent. Even the combined weights of few sectors such as financial services, oil and gas, information technology, and consumer goods are more than three-quarters of the Nifty 50. This clearly points to a sort of concentration risk for these indices. And since index funds (or ETFs) mimic these indices, the concentration risk is replicated in index fund portfolios as well. And this isn’t correct from a risk management perspective. Active funds, on the other hand, have a much lower risk of concentration as their managers can take discretionary calls to reduce exposure to stocks/sectors when they become too large from an allocation perspective.

Also, SEBI has guidelines for funds that restrict them from owning more than 10 percent in a single stock. So, unlike index (or index funds), there are some rules to protect common investors from the concentration risk of over-exposure to few stocks, groups or sectors in the indices.

By the way, some of you may counter all this by saying that at least in index funds, there is no fund manager risk and that, it is difficult to pick the right large-cap fund each year and hence, it’s best to stick to index funds.

There is no denying that claim. But what I have stated about concentration risk is a fact too. But that doesn’t mean that you should write off index funds. Nothing like that. Index funds are great instruments and they can very well form part of one’s portfolio. But it’s always good to know what one is getting into. Isn't it?

And by the way, do you know why exactly active funds are now finding it difficult to beat their indices?

Explaining active funds’ underperformance

One reason is the SEBI rule forcing active large-cap funds to invest at least 80 percent in the top-100 stocks. Earlier, fund managers had the freedom to invest across a wider universe of stocks in search of alpha. But with the restriction of ‘80 percent in the top 100 stocks,’ the ability of active large-cap fund managers to generate benchmark-beating returns has been negatively impacted. Another reason is the switch from performance reporting from PRI to TRI (Total Return Index). It’s easier to beat a PRI based index than a total returns based index.

So, all said and done, what can one do? Is it time to move from active funds to index schemes?

Index funds can still be chosen for holding a major part of your large-cap exposure. Plain and simple. But do keep in mind the concentration risk you are taking. It can work wonders when high-weightage stocks do well. But it can also go down quickly if those stocks correct. Following a strategy that uses a combination of actively managed and passive index funds is the way to go. But to each her own!