The Role of Large Cap Funds In a Diversified Portfolio

If you are not yet comfortable in taking on too much risk and still learning the nuances of mutual funds in your investment journey, then large cap funds can be a suitable choice to test the waters. These funds are relatively stable and offer the potential for wealth creation over the long-term as they invest in well-established companies - the first 100 companies by market capitalisation as defined by the Securities and Exchange Board of India (SEBI).

In this article, we will explore how large cap funds function, how they may contribute to the creation of a diversified portfolio, and what can make them an appropriate option for certain types of investors.

Also, we will also look at the risk-return profile of large cap funds, compare them with mid- and small-cap funds, and look at the kind of value it adds in a diversified portfolio.

• Table of contents

• Large cap funds – Stability
• Large cap funds – Portfolio diversification
• Large cap, mid cap, and small cap funds – The comparison
• Large cap funds – Risk and return
• Large cap funds – Who should invest?
• Selecting the suitable large cap fund for your portfolio
• Large cap funds – Tax implications
• Tips to balance large cap funds with other asset classes

Large cap funds – Stability

Large cap funds primarily invest in companies that are considered financially sound and often have a long and consistent track record. These are the top 100 listed companies based on full market capitalisation, as classified by SEBI.

The reason why large cap funds are considered relatively more stable as compared to others is because large cap companies usually have sounder balance sheets, more regular cash flows, and are relatively less affected by short-term market fluctuations than mid-cap or small-cap funds.

Furthermore, large cap companies often hold leading positions in their sectors, which might make them more resilient during economic downturns compared to other smaller companies. Therefore, large cap funds aim for relative stability and steady growth potential over a long horizon, making them an option for investors who are unwilling to take on bigger risks. Although it’s important to remember that no investment is entirely risk-free, including large cap ones.

Read Also: Index Funds vs. Large Cap Mutual Funds: Which one to choose?

Large cap funds – Portfolio diversification

Less ups and downs

Large cap funds usually do not rise or fall in value as sharply as mid-cap or small-cap funds or even sectoral and thematic funds do. The net asset value (NAV) of these funds is usually relatively stable as the underlying companies tend to be well-capitalised and resilient.

Relatively steady in volatile markets

During uncertain or falling markets, large and established companies can remain relatively less affected compared to smaller and less established businesses. This makes them seem like a relatively more stable option for investors.

Regular income

Many big companies pay dividends regularly. This can give investors the potential for steady income in addition to the potential for capital appreciation.

Balanced investment option

Mixing large cap funds with other types (like small cap or debt funds) can help balance risk and potential returns. These plans can be considered by investors who have medium to long-term financial goals as these horizons align with the nature of equity funds––i.e., the potential for capital appreciation over an extended period.

Large cap, mid cap, and small cap funds – The comparison

Large cap funds

These are the funds that invest in the first 100 companies by market capitalisation. They are relatively less volatile and can provide the potential for relatively steady returns over a long horizon.

Mid cap funds

These are the funds that invest in 101st to 250th ranked companies by full market capitalisation. They are more volatile compared to large cap funds but may offer higher potential returns albeit with higher risks.

Small cap funds

These are the funds that invest in companies ranked beyond the first 250 by full market capitalisation. They can be extremely volatile with extreme price fluctuations but may offer a very high growth potential if the underlying companies succeed in their endeavours.

Large cap funds – Risk and return

Risks

Market risk: As these funds are equity-based, their returns may be affected by market volatility. However, large cap funds, by virtue of the relatively stable underlying companies––are associated with less risk as compared to mid cap and small cap schemes.

Sector concentration risk: If a large cap fund is heavily invested in a specific sector, changes in that sector may impact fund performance.

Potential returns

These funds may provide the potential for wealth creation over the long-term. Due to the relative financial stability of the underlying companies, sharp losses may be less frequent than in mid cap or small cap categories. However, the return potential is usually lower than that of mid cap and small cap funds.

Large cap funds – Who should invest?

• First-time investors: Individuals new to equity investing might find large cap funds more approachable due to their relatively stable nature.
• Conservative investors: Those who prefer to avoid excessive market fluctuations might appreciate the focus on large, established companies.
• Long-term investors: Equity investors with a horizon of five years or more can leverage the compounding effect where potential returns generate more potential returns.
• Retirement planners: Those planning for retirement may find these funds a reasonable choice as they aim for potential capital appreciation over the long-term.

Read Also: How Large-Cap Funds Help to Achieve Financial Goals

Selecting the suitable large cap fund for your portfolio

Track record

Before investing in a scheme, evaluate consistency in performance. Many schemes may project short-term numbers but those are not indicative of their overall performance. It is prudent to assess how a large cap fund performed across different market cycles, even though it doesn’t guarantee future returns.

Expense ratio

A higher expense ratio may eat into your potential returns, especially over a long horizon. A lower expense ratio means you get to keep more of your potential returns.

Fund manager’s experience

Look for an experienced fund manager with enough understanding of the market and a track record of navigating through various market phases.

Portfolio holdings

It is very important to go through the companies a particular fund has invested in. Check whether the companies are well-diversified across various sectors to avoid concentration risk.

Large cap funds – Tax implications

Gains arising from sale of large cap fund units after they are held for more than 12 months, are treated as Long-Term Capital Gains (LTCG). These are taxed at the rate of 12.5% above the Rs. 1.25 lakh exemption limit in a financial year.

If units are sold before 12 months, the gains are considered Short-Term Capital Gains (STCG) and taxed at 20%.

While these are the latest taxation rules for equity funds, consulting a tax advisor for tailored investment solutions can help one in optimsing one’s tax outgo.

Tips to balance large cap funds with other asset classes

A diversified portfolio does not rely on one fund category. While large cap funds can bring relative stability and the potential for long-term capital appreciation, it is important to balance them out with other assets to optimise the overall risk-return profile of your portfolio, and potentially meet your financial goals.

Mid cap or small cap funds

Adding mid cap or small cap can give your portfolio a chance for more substantial potential returns, as they have higher growth potential but are also associated with greater investment risk.

Debt funds

Debt funds can provide stability and help mitigate risk when the stock market shows volatility.

Gold or real estate investments (like REITs)

Investing in gold or property-related funds can further spread investment risk, which can offset the underperformance in a particular asset class.

Conclusion

Large cap funds invest in established companies with a history of relatively stable performance. Therefore, these funds may be suitable for investors looking for potential wealth creation over a long horizon, while also being relatively more stable than mid-cap or small-cap funds. However, it’s not recommended to build a portfolio containing only large cap assets. It is important to diversify across asset classes and sectors to mitigate risk.

FAQs:

What are large cap mutual funds and how do they work?

Large cap mutual funds invest in the top 100 listed companies by market capitalisation. These companies are often considered financially stable and leaders in their segments, thus making the funds that invest in them relatively less volatile.

Are large cap funds good for long-term investment?

Large cap funds may be suitable for long-term or conservative investors due to their focus on established companies and the potential of equity investments to appreciate over a long horizon.

How do large cap funds help in reducing portfolio risk?

Since these funds invest in companies with stronger financials and market leadership, they may be relatively less affected by market volatility compared to funds that invest in smaller companies. The relative stability can help mitigate the risk posed by other aggressive investments in a portfolio.

Can I combine large cap funds with small-cap funds in my portfolio?

Yes, combining large cap and small-cap funds can help create a diversified portfolio. Large cap funds can offer relative stability and long-term growth potential, while small-caps may provide higher potential return albeit at a much higher risk.

How do I choose the best large cap fund in India?

There is no “best” fund as such. You should look for a fund suited to your needs and risk tolerance.