The debate around active versus passive investing in large-cap stocks has largely been settled. Data shows that only 73% of large-cap active funds couldn’t beat the index over 10 years, with winners outperforming by a modest 1-3%. For most investors, index funds offer a simpler, cheaper path to large-cap exposure.
Yet, PPFAS Mutual Fund recently announced the launch of an active large-cap fund. This move raises an obvious question: why enter a space where the odds of consistent outperformance are demonstrably low? The answer lies in a different approach altogether.
Let’s first understand:
Why Traditional Large-Cap Active Management Faces Structural Challenges?
SEBI’s 2018 regulations fundamentally changed the large-cap fund landscape. These funds must now invest at least 80% of their portfolio in the top 100 stocks by market capitalisation, with only 20% allowed outside this universe.
This rule pushes portfolio overlap with benchmark indices to roughly 60-70%, leaving minimal room for differentiation through stock selection. The remaining 40% active portion carries an impossible performance burden. After accounting for the approximately 0.9% higher expense ratio compared to index funds, fund managers must generate substantial alpha from this limited slice.
The mathematics is unforgiving. To beat the index by just 1% annually, that 40% active portion must outperform the market by 4.7% every single year. Expecting any manager to deliver this consistently for 10-15 years stretches credibility.
Several structural factors compound this challenge.
- Limited Stock Universe: Only the top 100 stocks by market cap qualify as large caps. A flexi-cap or small-cap manager can search across thousands of stocks for opportunities. A large-cap manager operates in the most visible, competitive segment of the market.
- Concentration Limits: At times, a handful of heavyweight stocks with 12-15% weight in the index drive the majority of returns. Active funds cannot mirror this concentration because regulations cap individual stock exposure at 10%.
- Information Efficiency: Nifty 50 stocks are tracked by over 500 analysts, with 20 research houses publishing daily reports. Nearly every insight is already priced in before most investors can act on it. India’s increasing institutionalisation compounds this. EPFO and NPS inflows have grown sevenfold in the past decade, from ₹12,000 crore in FY16 to ₹84,000 crore in FY24, bringing more capital into these stocks.
The One Advantage Active Funds Retain
Index funds operate under a critical constraint: they must remain 95% invested at all times, regardless of market conditions. They cannot raise cash, reduce exposure, or shift to defensive positions when corrections appear imminent.
This structural limitation means index funds absorb the full impact of drawdowns with no protection mechanism. Active funds retain the flexibility to manage exposure during volatile periods. This ability to time drawdowns represents their primary structural advantage over passive strategies.
PPFAS’s Perspective: Execution Over Selection
PPFAS identifies its opportunity not in picking better stocks than the index, but in acquiring the same stocks at better prices. The fund house believes it can capture small, consistent arbitrage opportunities that emerge from structural inefficiencies in Indian markets.
The strategy involves maintaining nearly identical weights to the Nifty 100 while keeping costs low at 0.1-0.3% total expense ratio. The value proposition centres on execution advantages that passive funds simply cannot exploit.
Understanding Arbitrage Opportunities
India operates two parallel markets: the cash market, where actual shares trade, and the derivatives market, where futures contracts change hands. Price discrepancies between these markets create arbitrage opportunities.
Consider a simple example with Titan. On a given day, Titan shares might cost ₹100 in the cash market while Titan futures trade at ₹103 in the derivatives market. An arbitrage strategy would simultaneously buy Titan shares at ₹100 and sell Titan futures at ₹103.
This locks in a ₹3 profit per share, regardless of whether Titan’s stock price subsequently rises or falls. The profit settles on the futures expiry date when the fund delivers the shares it bought and receives the futures price it locked in earlier.
PPFAS already employs such strategies in its flexi-cap fund and dedicated arbitrage funds. The firm believes these same techniques can add incremental value in the large-cap space.
Five Execution Strategies Passive Funds Cannot Use
1. Futures-Cash Arbitrage
When futures trade below cash market prices, active funds can buy the cheaper futures instead of the stock itself.
For instance, if United Spirits trades at ₹1,312 in the cash market but futures are available at ₹1,305, the fund can buy futures at the lower price and sell cash shares at the higher price. On expiry, it converts the futures to actual shares, locking in a ₹7 risk-free profit.
Index funds cannot execute this strategy. They must buy the actual shares at whatever the cash market price is.
These opportunities are fleeting. The moment a price gap appears, algorithms across multiple funds spot it and execute trades within milliseconds, closing the gap almost instantly. These aren’t opportunities found by humans watching screens but captured by automated systems programmed to identify pricing inefficiencies.
However, funds face an important constraint: they cannot hold naked futures positions. SEBI mandates that all derivatives positions must be backed by equivalent cash or stock holdings. To buy futures, funds must hold sufficient cash. To sell futures, they must own the underlying stock or have the ability to borrow it.
2. Buying Index Futures During Panic Discounts
During extreme volatility, Nifty futures often fall more sharply than the spot index itself. During the COVID crash, futures traded 0.5-0.8% cheaper than the index.
This happens when foreign institutional investors and large traders aggressively short Nifty futures to hedge portfolios or speculate on further declines. This selling pressure drives futures prices down faster than the spot market, creating temporary discounts.
Instead of buying all 100 stocks at full cash prices, an active fund can purchase index futures at a discount. Importantly, long index futures positions can be backed by government securities or Treasury bills, not just cash, providing additional flexibility.
3. Merger Swap Arbitrage
Merger announcements create temporary price gaps between the acquiring and target companies. The market takes time to fully price in announced swap ratios.
The HDFC Ltd and HDFC Bank merger provided a clear example. On certain days, it was cheaper to buy HDFC Ltd shares and still end up with more value after the merger was completed.
4. Pre-Positioning Before Index Rebalancing
Additions and deletions to indices like Nifty are announced weeks in advance. Index funds are forced to buy new entrants only on the official rebalancing day, creating predictable price surges.
Trent’s stock rallied 83% in the six months before its Nifty inclusion was even announced. An active fund can accumulate the stock gradually over time, securing a better average price instead of buying at an inflated peak on rebalancing day.
5. Avoiding Forced Selling During Demergers
When a company splits, and the new entity is too small for index inclusion, it gets removed from Nifty or Sensex. All index funds must sell on the same day, creating concentrated selling pressure.
ITC Hotels, after the ITC demerger, exemplified this. Heavy forced selling pulled the stock down temporarily. An active fund can avoid selling at the bottom or even buy during the dip, while passive funds have no choice but to sell.
The Target Investor
PPFAS frames this product for investors who want index-like return predictability but believe small, consistent execution advantages can add incremental value over time. The bet is not on superior stock-picking but on exploiting structural inefficiencies through better trade execution.
Whether these micro-advantages compound into meaningful outperformance over 10-15 years remains an open question. The historical data on large-cap active management suggests scepticism is warranted. Yet the strategy represents a different approach than traditional active management, one that acknowledges the difficulty of stock selection while attempting to add value through execution efficiency.
Conclusion
This perspective challenges neither the efficiency of passive investing nor the data showing that most active funds underperform. Instead, it identifies a specific niche: investors who accept index-like exposure but believe micro-arbitrage opportunities can generate small, consistent gains without taking on stock selection risk.
The approach recognises that in an increasingly efficient large-cap market, superior returns may come not from picking different stocks, but from acquiring the same stocks more intelligently. Whether this thesis holds up under real-world conditions will become clear only with time and independently verifiable results.
Finology is a SEBI-registered investment advisor firm with registration number: INA000012218.
Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before making any investment decisions.
