Why do large-cap mutual funds keep falling short of their benchmark?

The Story

India’s equity market has experienced a steady and impressive bull run since the pandemic. Despite this, over the last five years, around 15 out of 25 active large-cap funds underperformed their respective benchmarks. An underperformance rate of 60%.

Another S&P study of December 2023 suggests that 52% of actively managed large-cap funds underperformed the S&P BSE100 in the past year.

These jaw-dropping numbers make us wonder why active large-cap mutual funds find it tough to beat their benchmark. Let us see.

Why Does This Happen?

1. SEBI’s Categorization Rules: Large-cap funds are required by the SEBI to invest a minimum of 80% in large-cap stocks and as per the categorization rules, the top 100 companies by market cap are large-cap funds. The rules restrict large-cap fund managers’ stock selection, making it more difficult to outperform the index.

2. Fund Manager Bias: Large-cap active funds may underperform because their stock universe is smaller. While there’s plenty of information available, fund managers often end up heavily betting on certain sectors or stocks. If those picks don’t pan out, beating the benchmark becomes tough. This bias in stock selection has led to underperformance, especially when the under-invested stocks perform unexpectedly well.

3. Cannot hold more than 10% in a single stock
The Nifty 50 has a 12.11% weight allocation towards HDFC Bank. In contrast, a mutual fund cannot hold over 10% in one company/stock as per the SEBI rules. Now, when a heavy-weight company in the benchmark index moves up drastically, the benchmark index will do better than active large-cap funds.

To Conclude

Active large-cap mutual funds’ failure to beat their benchmarks is not just a result of market conditions, as these funds are subject to regulatory constraints and other structural problems.

These factors make it harder for them to perform better than the index. As an investor, it’s worth considering these factors for informed decisions.