Ask Morningstar: Why must a large-cap fund be a core holding?

May 05, 2022

What is the logic of a core holding of a portfolio?

I often seen recommendations to have a large-cap as one. Why can’t a BAF or arbitrage fund be the core holding?

Also, does it make sense to have more than one large-cap fund in a portfolio? After all, the universe that they invest in is small.

Can you suggest a portfolio for me? I am in my late 20s and starting from scratch.

Let me answer each of your questions individually.

  1. What is a core holding and what’s the logic behind it?

In simple terms, core holding of a portfolio is the one which comprises of the maximum part of the portfolio. The idea of having a core holding is that it should play an anchors role in the overall portfolio. This means that a core holding is the one which provides good return during favourable environment, and at the same time, it should limit the volatility in the portfolio during challenging times. The core holding or an allocation to core holding can vary based on various factors such as investors investment objective as well as risk appetite.

  1. Why large cap as core holding?

Equity investments are one of the most essential components of a portfolio if an investor wishes to create long-term wealth. Given their propensity to generate high return compared to other asset classes, their role in the portfolio cannot be overstated. But equities tend to be volatile and relatively riskier asset class as well. Hence, while constructing a portfolio these aspects should be taken into consideration. Therefore, the portfolio must be constructed in a way that it is comparatively stable during tough times but at the same time not limiting its ability to generate returns.

When we look at different market segments viz. large-cap, mid-cap and small-cap; large cap tends to be less volatile compared to mid-caps, which in turn is relatively less volatile than small cap stocks. This is the reason why large caps are suggested to be the core holding of a portfolio. While they provide stability to the portfolio during market downturn, mid and small caps can provide a kicker when the market moves up. So, a right combination of these three segments in the portfolio can help withstand different market environments. However, the allocation to these segments may vary based on investors risk appetite. Still, large cap holdings should ideally have higher allocation compared with mid and small caps.

  1. Why not Balanced Advantage Fund or Arbitrage Fund be the core holding?

In Balanced Advantage Funds the allocation between equity and debt investments are managed dynamically, which means that a manager can freely increase or reduce exposure in either equity or debt investment depending on his view. For instance, when the equity markets turn expensive with respect to valuations, the manager can prefer moving more towards debt and vice-versa. As per the current construct of the category, the average equity exposure in the category has been in the range of 40-50% in the last one year, whereas the average allocation to debt and cash investments have been in the range of 50-60%. Therefore, these funds adjust their allocation towards equity and debt based on market valuations rather than investors risk appetite. So, for a high-risk investor, whose asset allocation suggests, say around 80% allocation to equities, these funds may not always meet that requirement. That said, such funds can be a good starting point for investors since they get asset allocation benefit here. Also from diversification perspective, they can form a part of the portfolio in a way that its equity and debt allocation meet the overall asset allocation requirement of the portfolio.

Arbitrage funds on the other hand are market neutral funds which leverage arbitrage opportunities in the market. Now these arbitrage opportunities can be in terms of pricing mismatch of a stock in two different exchanges or different pricing in the spot and futures market. The fund manager of an arbitrage fund buys and sells the stock at the same time in order to clock the difference between the selling price and the buy price. This difference in selling and buying price is the return for the fund. Since the idea is to capture the difference in pricing, their returns are much lower than a regular equity fund. Hence, they cannot form the core portion of the portfolio.

  1. Does it make sense to have more than one large cap fund in the portfolio?

Yes, it makes sense to have more than one large cap fund in the portfolio because it would provide diversification across asset management companies, fund manager and investment styles. While selecting funds, one should focus on adding funds which are managed with different investment styles. In the large cap category, there are funds like HDFC Top 100 which are managed with valuation conscious approach and then there are funds like Axis Bluechip which follow growth-oriented approach. Hence, these are two contrasting investment styles with different return pattern and therefore can compliment each other well in a portfolio. That said, investors should be judicious in selecting funds and should not also overcrowd the portfolio with lot of funds. If one can reach adequate diversification with the help of 2-3 funds, its fine.

Your personal portfolio plan

There is lot more information required before one can recommend a portfolio.

I suggest that you employ the services of an investment adviser who will suggest the right investments based on your age, current income, liabilities, risk appetite, and investment goals. And who can regularly monitor your portfolio in line with your changing personal circumstances.

Having said that, here are some pointers.

Asset allocation is the building block of any investment plan. So, the first step is to have the right asset allocation mix which depends on your investment goal and risk appetite.

Given your age, and considering you as high-risk taking investor, you can consider investing 80-85% of assets in equity-oriented funds and 15-20% of assets in debt-oriented funds to start with.

Of the overall portfolio, you can invest around 40% of assets in large-cap funds, 25-30% in mid-cap funds and 15-20% in small-cap funds. As we have discussed earlier, a well-diversified portfolio is better positioned to ride testing times, and therefore, large-cap funds, due to their stable nature, should be the anchor your portfolio. Subsequently, mid and small cap funds would provide a kicker to the portfolio when these segments hit a purple patch. They are a high-risk, high-return investment proposition. While they can be extremely rewarding during certain market phases, they can also cause severe dent during adverse environments. Therefore, long-term is the key when it comes to investing in equities. So, your investment horizon in equities should not be less than 5 years.

On the debt side, you can consider funds from the ultrashort, money market, short duration and corporate bond segments, which do not take any credit risk.

Here is where you can access our analysts' views on funds from various categories.

Registered readers can post their queries by accessing the Ask Morningstar tab. Our team will answer SELECT queries relating to mutual funds, portfolio planning and personal finance. While we provide broad guidelines, we suggest you consult a financial adviser before making investment decisions.


Articles authored by HIMANSHU SRIVASTAVA

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