Today, equity investors are in a peculiar situation. On the one hand, many large-cap equity funds are unable to outperform the benchmark and on the other, investors are finding it difficult to avoid them as they are less volatile and offer greater stability to a portfolio than mid-and-small-cap equity schemes.

So, how do investors navigate this situation of remaining invested in large-cap equity schemes and still pocket some extra returns over benchmark? Some make peace with the situation by investing in a large-cap index ETF, wherein they get large-cap exposure but have to forego outperformance. Some investors, instead, try to pick an actively managed equity fund that may outperform the benchmark.

Though for many, checking the past performance of a scheme is the way to select one for investment purposes, it is not the best predictive tool as the past does not guarantee the future. Investors need conviction, which can be built only when they use tools that can explain the future.

When an investor is looking for more returns than the benchmark return, he should first look for a portfolio that is different from the benchmark. If mimicking the benchmark means pocketing similar returns before costs, then in search of higher returns one has to differ when it comes to portfolio construction. It is here a reliable predictive tool that comes to the aid of investors—Active ratio or active weight.

Active weight or active ratio is defined as how much a scheme’s portfolio holdings differ from those of its benchmark. It is calculated as the sum of the absolute difference between the weights of securities in a given portfolio and weights of securities in the benchmark divided by two.

A number less than 30 percent (of active ratio) means there is not much difference in the scheme’s portfolio and the benchmark. Such portfolios are referred to as closet index portfolios. Also referred to as ‘index-hugging’ schemes, they tend to deliver returns closer to the index in the long term.

If the active ratio stands at more than 30 percent, the fund manager is said to be taking ‘active calls’. These portfolios can offer returns meaningfully different than those offered by the benchmark.

Why should an actively managed portfolio differ from the benchmark?

A benchmark is typically constructed on the basis of free-float market capitalization. While managing an active scheme, the fund managers pick stocks primarily based on the business fundamentals. Focus is on picking businesses that are expected to do well and avoiding businesses that have poor prospects.

A high level of conviction of the fund manager is indicated by large money allocation to each stock picked. Consequently, a portfolio is created comprising less number of stocks with relatively larger allocation compared to other diversified equity schemes. Some analysts refer to such portfolios as ‘focused’ portfolios. They typically exhibit a high active ratio.

Most mutual fund databases do not offer active ratio. You can source it from your financial advisors. You can calculate it yourself as well by using the aforesaid formula – the sum of the absolute difference between the allocation of securities in a given portfolio and allocation of securities in the benchmark divided by two.

If a fund manager’s selection and exit of stocks proves effective, such schemes generate superior returns compared to their benchmark.

The inclusions of stocks of fundamentally sound companies with high allocation to them offer superior returns. At the same time stocks with poor fundamentals, if excluded, means the scheme’s downside is contained.

Winners bring in excess returns and avoiding losers offer stable experience to investors – the recipe the investors are looking for in an actively managed large-cap fund. Hence, while investing in a large-cap scheme investors must pay attention to Active Ratio or Weight over a reasonable period of time.

Avoid making an investment decision based on the number at a given moment of time. Instead, look for a consistently high active ratio over a period of time. This will give them a fair idea of how much “excess” return that particular scheme can generate over a long period of time.

- By Siddharth Bothra, Fund Manager, Motilal Oswal Asset Management Company