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How are index funds different from large-cap funds?

Over the last couple of years, there have been talks about how index funds are performing better than actively managed mutual funds. First, let us look at why some of the large cap funds are just not able to beat the benchmark index.

Index fund vs large cap fund

A few years back, the Securities Exchange Board of India (SEBI) recategorised mutual funds. Why? This was to make sure that different schemes launched by mutual fund houses are clearly distinct in terms of asset allocation, investment strategy etc. Further, this was to bring in uniformity in the characteristics of similar type of schemes launched by different fund houses. This was to help investors to evaluate the different options available before taking an informed decision to invest in a mutual fund.

After the categorisation of mutual funds, large-cap funds had to invest a minimum of 80% of their portfolio in the top 100 stocks as calculated based on the market capitalisation of the stocks. Due to this, large cap funds are struggling to beat the benchmark index that is available at a lower cost. Note that before the recategorisation, several large-cap funds could take exposure to mid- and small-cap stocks and this helped them generate higher returns.

Now, what are the differences between index funds and large cap funds?

Large cap funds are actively managed funds. Funds where the fund manager decides which companies to invest in based on their research are called actively managed funds. All large/mid/small cap funds are actively managed funds.

Index funds are passively managed funds. Funds that track or mimic the composition of an index are passively managed funds. The index could be Nifty 50, Nifty Midcap 100, BSE Small cap, etc. For example, an Index fund tracking Nifty 50 will invest in all the 50 companies on the Nifty.

So, in a large cap fund, the fund manager decides which stock or sector to invest in. An index fund just tracks the benchmark index. There is no market research or intelligence involved here.

Since market research skills are needed for large cap funds, these funds have higher expense ratio compared to index funds. The biggest advantage of an index fund over a large-cap fund is its low cost. Fund management cost of an index fund can be as low as 0.17% whereas large cap funds charge anywhere between 1.5% to 2.25% as fund management charges.

Then, come the fund performance. Note that if the large cap fund manager’s views are right, the fund will generate higher returns or will outperform the benchmark. However, if the views don’t turn out to be right, it can lead to lower returns or under performance. For index funds, the returns will mimic that of the index.

The volatility of the index funds is generally comparatively lower than that of large-cap funds.

Who should invest in large cap funds?

Investors with a low level of risk tolerance can consider large cap funds. Investors who belong to the elderly age group or those who are nearing retirement should consider adding large cap funds to their portfolio. Even those who are looking at income can consider large cap funds with a good dividend history. The steady flow of dividend acts as a stable source of income. Investors with a long investment horizon and looking to invest for long term goals could channel their investments towards large cap funds. When compared to mid-cap funds and small cap funds, large cap funds are less risky.

Who should choose index funds?

First time mutual fund investors can consider index funds. It is a good way of getting introduced to the market at lower costs and lower risks. Those investors who are nearing their age of retirement could consider Index funds. Investors with low risk profile and limited capital can try index funds.

What’s the buzz in the marketplace?

With several large cap fund managers mimicking the benchmark index, wealth managers and other financial experts feel investors can make large cap allocation using low cost index funds. In these, fund managers don’t hold on to cash and there is no fund manager bias.

There are others who are saying that if you are going for an actively managed fund it is best to choose multi cap funds rather than large cap funds. Why? This is because these funds have the flexibility to choose stocks across the large cap, mid cap and small cap categories. So, while risk-averse investors can choose index funds, those with a medium or high-risk appetite could consider focused funds as part of their large cap allocation. If you are not sure about which fund suits your risk profile, financial situation and life goals, get in touch with your consultant at wealthzi.com.

Hindsight bias in investing

What do you feel when the clouds in the sky are dark? You may say that it will rain or that this will pass. Just in case it rains later, you will just believe that you had felt it will rain. This belief that you had already predicted that something will happen is known as hindsight bias. Let’s consider another example.

Suppose you are viewing the Indian Premier League’s last cricket match and your preferred team is playing. You may think the adversary will win or that the match will be a draw. In any case, if your group wins, you will tell everybody that you had predicted their win long back.

While examining the consequences of a sporting event with your companions or while hearing TV characters talk about races, you may have seen individuals guaranteeing they ‘knew it from the start’. This inclination to investigate the past and think we anticipated the end is known as hindsight bias.

Hindsight bias and decisions

At the point when events have occurred, you are simply following the breadcrumbs like Hansel and Gretel to understand what prompted them to happen. This is surprisingly straightforward. At the point when you definitely know the end result of an event, it’s anything but difficult to find how it could have occurred. Anticipating the future without knowing the end is an altogether other issue.

Along these lines, hindsight bias drives you to have a misguided feeling of trust in your capacity to foresee events. You think you have settled on profitable choices. It frequently entices you to make striking estimates and gives you an incorrect conviction that all is well with the world. This inclination leads to imperfect reasoning and poor decision making which could be dangerous when you are investing.

Investing bias

Suppose you purchase a stock and the stock value falls. You will imagine that you realized that it will fall. However, in the event that you make gains on the stock, you will feel glad that you made a wise decision. At the point when your investments are making gains, you ascribe it to your capacity to choose wise investments when you didn’t get any assistance. You will in general overestimate your capacity to pick increasingly good investments. In any case, since one of the investments progressed admirably, you can’t presume that different investments will do well. It’s difficult to foresee with conviction which investment will be a winner for experts themselves, leave alone beginners. This predisposition could lead to lower returns for your portfolio.

Take mid-cap stock values, for example. A financial expert who took a look at the twofold increase in the returns of mid-cap stocks from 2017 to 2018 may have assumed that 2019 will be an extraordinary year to place everything into this market. Without a doubt, this financial expert would have been frustrated to see a negative drop in mid-caps.

Another point is that the hindsight bias can lead investors to ignore the fundamentals of a company or mutual fund. For stocks, adhering to intrinsic valuation strategies enables an expert to guarantee that their investment choice is unprejudiced and is only dependent on information driven variables and not on personal ones. Intrinsic worth is the view of a stock’s actual worth. This valuation depends on all parts of the business and could possibly not be in line with the present market value. In this way, picking a stock or mutual fund on hindsight bias is not the right thing to do.

Hindsight bias can often result in investors regretting at not noticing trends earlier. For instance, an investor may take a look at the credit defaults by an organization as something that ought to have been foreseen since the organization was having extreme budgetary issues before. This can’t be foreseen by novice investors.

How to overcome the bias?

The best guard that you have against this bias is making a long run investment plan. Judicious investors will abstain from timing the market. Indeed, even market experts can’t state how the market or stock will move. Along these lines, don’t make focused bets on a solitary stock or mutual fund. Rather, take the help of a financial planner or do your own research to buy investments such as stocks and mutual funds. By taking note of your long-haul objectives and having a plan, you won’t be enticed to make impulsive investment choices.

Another way to avoid hindsight bias is by becoming knowledgeable. Despite the fact that you may want to invest in a stock or mutual fund, it is a good idea to ask experts, companions or set out to find out more about the investment yourself. For instance, in the event that you have chosen to purchase a stock, search for reports and news stories that help your choice. This will assist you with keeping away from the hindsight bias. Look into research papers that will help you in making a more holistic investment decision.

Understand that it is common to commit errors. However, you shouldn’t do those errors once more. Observe the slip-ups you made before and make sure that you make the correct moves now. For instance, if you put resources into a stock for the short term and it didn’t work out, don’t repeat the mistake. Consult market experts for such investments and always invest for the long run. Just concentrate on the correct investment choices.

How changes in interest rates affect your portfolio

Consistently, the Reserve Bank of India (RBI) changes the interest rates in the nation utilising its fiscal strategy. This influences various loans and deposits. You realise that loan rates change. Nonetheless, do you realise that your investments get influenced as well? Interest rate dynamics affect your investments too. In the recent years, RBI has been cutting interest rates. s

Why the rate cut

Lower loan costs encourage consumer spending in the economy. This gives the country a lift when it is in the midst of slower economic growth. Lower interest rates mean lower loan rates and this urges enterprises to obtain and put the cash in maintaining their business. When organisations progress well, the economy does well too.

In this way, the RBI utilises the fiscal strategy to keep the economy fit as a fiddle. At the point when the economy is developing and in great condition, RBI takes measures to increase loan costs to keep inflation under control. RBI controls the repo rate, which impacts long term loan fees in the nation. Repo rate is the rate at which RBI lends cash to banks in case of any deficit. By setting the repo rate, the RBI in a roundabout way changes long term interest rates, which boosts spending and in the long run encourages industrial and economic prosperity.

Now, how does this affect your investments?

Stock investors

Interest rate changes do not have any direct impact on your stocks. However, RBI’s actions can have a trickle-down effect. For instance, when RBI increases interest rates, banks increase their loan rates and increased rates for business loans can cause companies to halt expansions and reduce employment. Reduced business spending will lower the value of a company’s stock. The reverse will be true when RBI cuts interest rates.

However, note that there is no guarantee that a rate cut will positively impact stocks or a rate hike will reduce stock prices. For instance, falling interest rates happen during periods of economic slowdown coinciding with a bear market. So, stock prices might fall. The impact of the interest rate changes will depend on the stock you chose to invest in.

Debt investors

There is a direct correlation between interest rates and fixed income investments. For these investors, change in interest rates can have significant portfolio implications. How? Bonds and interest rates have an inverse relationship. When interest rates fall, bond prices will rise. When interest rates rise for an extended period, bond prices will decrease. Why does this happen? Newly issued bonds will have higher yields after interest rates rise, making bonds with low coupon rates worth much lesser.

Change in interest rates can directly impact bond yields. Long-term bonds having maturity ranging from 10 to 30 years will have substantial effects. Short-term bonds are less affected by interest rate changes.

If you have bond holdings in your portfolio, such as bond funds, liquid funds or money market funds, falling rates mean a lower return on your investment. If there is an increase in interest rates, deposit rates and debt fund returns will go up. However, understand that interest rate changes impact you, as an investor, only if you are going to redeem your bond holdings.

Let’s consider an example. You purchased a bond for Rs. 3,000. The RBI increases the interest rate and our bond’s market value drops to Rs. 2,900. So, the loss is Rs. 100. However, this loss is only on paper and if you hold the bond to maturity, you will still receive Rs. 3,000. Understand that most times bond price decreases will be offset by bond price increases at a later date if you stay invested.

Other investments

If you have invested in commodities, their prices will increase when interest rates fall and prices may fall when interest rates rise. For instance, gold prices touched an all-time high in India after RBI cut interest rates. If you have property holdings, an interest rate cut can be beneficial. Real estate prices are directly related to interest rates due to the cost of financing. Real estate becomes more attractive as interest rates fall.

What to do?

As interest rate changes can affect investments in different ways, there is no single action you can take. Knowing how to manage your portfolio can help mitigate any potential negative effects. Assess your portfolio and look at how individual asset classes are likely to be impacted by the interest rates. Based on how your portfolio is structured, you can decide whether you should take any action.

You should analyse each investment. For instance, in case of stock investments, try and analyse the industries that might get impacted by interest rate changes. Cyclical industries such as financial institutions, industrial companies, and energy providers tend to perform better when rates rise. Real estate, utilities, and telecommunication, might perform well when interest rates fall.

If you don’t want to do all this, just build a diversified portfolio made up of quality stocks and bonds. Diversifying can help preserve your overall investment portfolio from the negative effects of changing interest rates in the long run. With a balance of stocks and bonds, your portfolio will be better positioned to maintain stability.

Work with wealth consultants at Wealthzi.com to understand how you can minimise the risks arising from interest rate changes to your portfolio.

How to rebalance your portfolio

When you set up a portfolio, you will have an asset allocation for your portfolio. Asset allocation is an investment strategy that helps balance the risks and rewards associated with investing by apportioning the portfolio’s assets as per your goals, risk tolerance, and investment horizon. In simple terms, you will set the percentages for investments in debt and equity and the cash that you will maintain. However, these percentages don’t remain the same throughout your investing horizon. They change based on the equity and debt market movements. Let’s understand how this happens.

Let’s say given your risk tolerance, financial goals and their time horizon, you have decided that your portfolio should look like this:

Asset	%	Rs.
Equity	60	6,00,000
Bond	35	3,50,000
Cash	5	50,000

Over the years, the markets seem to be doing really well and a couple of your shares zoom ahead and before you know it, your portfolio changes to:

Asset	%	Rs.
Equity	71.0	11,00,000
Bond	25.8	4,00,000
Cash	3.2	50,000

You might want to ask, ‘What’s the problem? I gained Rs. 5,00,000 – isn’t that a good thing?’ Of course, it is. However, the problem is that, you have moved away from your original asset allocation and possibly exposed yourself to more risk than is not in line with your risk profile.

This is where you, as a sensible investor, should take some action to bring the portfolio back to the original asset allocation. This is rebalancing.

What is rebalancing?

Rebalancing is the process of buying and selling parts of your portfolio in a bid to rearrange the weight of each asset class back to its initial proportions. In simple terms, it is returning your portfolio to the proper mix of equities, debt and cash when they no longer conform to your financial plan.

Portfolio rebalancing will help you keep your portfolio in line with your financial plan. Understand that rebalancing is not an endeavor to time the market. You need to consider it as a timely reassessment and modification of your investments that will help you reach your goals while ensuring that your risk profile isn’t ignored.

How to re-balance your portfolio

There are different methods for rebalancing your portfolio.

Calendar rebalancing

Calendar rebalancing is the most basic approach. This involves analysing your investments in the portfolio at scheduled time intervals and then adjusting them to the original allocation at a preferred frequency.

Quarterly assessments might be preferred for equity investments because monthly or weekly rebalancing could be overly expensive. A yearly approach could also be considered if you have a higher risk appetite. You should determine the ideal frequency of rebalancing based on time constraints, transaction costs and your risk profile. A major advantage of calendar rebalancing over other methods is that it is less time consuming and least expensive for you as it involves less trades and the assessments are made at pre-determined dates. The downside to calendar rebalancing is that it does not allow for rebalancing on a more dynamic basis even if the markets change significantly.

Here’s how to rebalance using calendar rebalancing.

First you need to record your investments. If you have decided on an asset-allocation strategy and have purchased the right securities in each asset class, keep a record of the cost of each investment at that time, as well as the total cost of your portfolio along with the percentages for each of the asset classes. This historical data will help you compare them with present values in the future.
On a chosen date, review the value of your portfolio and of each asset class. Calculate the percentages for each asset class in your portfolio by dividing the value of each asset class by the total portfolio value. Compare this to the original percentages. Note if there are any significant changes. If not, it may be better to remain passive.

Constant rebalancing

A more responsive approach to rebalancing is constant rebalancing. Every asset class is given a target percentage and a corresponding tolerance range. For instance, an allocation strategy might say that the requirement is to have 30% in mid-cap equities, 30% in blue chips and 20% in bonds with a range of +/- 5% for each of these asset classes. Note that mid-cap equities and blue chips can fluctuate between 5% and 35%. When the percentage of any one asset class moves outside the allowable band, the entire portfolio needs to be rebalanced to reflect the initial asset allocation.

You can use any one of these portfolio rebalancing techniques.

When you find that changes in your asset class percentages have distorted the portfolio, take the present value of your portfolio and multiply it by each of the percentages originally assigned to each asset class. The figures you get will be the amounts that should be invested in each asset class to maintain your original asset allocation.
To achieve the original asset allocation, you could sell off some of the shares where profits have exceeded your expectations and invest those profits in debt. Another alternative will be to look at your other equity holdings and sell the underperformers. You could even introduce new shares or bonds in your portfolio to bring those percentages back to where they were.

It might seem okay to leave the portfolio alone, especially if you have made profits. However, the purpose of having an asset allocation is to achieve the best return for your risk appetite. Doing nothing will violate this. As a rule of thumb, when your allocations drift by 10% or more from your original allocation, you should re-balance. This could happen over time or following an abrupt rise or decline in one or more asset classes.

Portfolio rebalancing helps you stick to your financial plan. You should check your portfolio once a quarter and more frequently if there is significant gain/loss in an asset class.

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Index fund vs large cap fund

Now, what are the differences between index funds and large cap funds?

Who should invest in large cap funds?

Who should choose index funds?

Hindsight bias and decisions

Investing bias

How to overcome the bias?

Why the rate cut

Stock investors

Debt investors

Other investments

What to do?

What is rebalancing?

How to re-balance your portfolio

Constant rebalancing

Categories

360 degree wealth management platform

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