How to Reduce Portfolio Risk Using Large Cap Funds?

Equity markets are considered to be highly rewarding, but equally unpredictable, especially when the portfolio focus is primarily on mid-cap and small-cap stocks. Unknowingly, many investors invest heavily in high-risk, high-return funds comprising small-caps and mid-caps, exposing themselves to excessive risk. As a result, portfolio value may sharply decline during a market correction, affecting the long-term wealth creation.

Is there a way to balance this risk? This is when large-cap funds play a major role as stabilisers. Large-cap funds that invest primarily in well-established blue-chip companies offer growth potential at reduced risk. Let us explore the practical ways to reduce overall risk and build a resilient portfolio using large-cap funds.

Why is Portfolio Risk Often Mismanaged?

Here are some key reasons why portfolio risk often gets mismanaged:

1. Investors focusing solely on the return, ignoring risk, is one of the common reasons. Especially when the markets are bullish, mid-cap and small-cap funds look more lucrative. Overallocation into these high-risk, high-growth segments can often lead to mismanagement of portfolio risk.
2. Lack of diversification or focus on similar market segments, sectors, or asset classes is another reason for portfolio risk to be mismanaged.
3. Choosing funds based on the recent performance or recency bias increases overall portfolio risk. For example, if small-cap funds have delivered impressive returns (very high) in the last three years, many investors tend to allocate 60% to 70% of their portfolio into these funds, increasing the potential portfolio risk.

Maintaining a balanced portfolio with sufficient large-cap exposure can balance the risk.

What Makes Large Cap Funds Relatively Stable?

Large-cap funds primarily invest in companies that are industry leaders, ranked up to 100 by market capitalisation as per the guidelines of SEBI (Securities and Exchange Board of India). Here are reasons why they are relatively more stable than mid-cap and small-cap funds:

1. Established business models, strong financials with consistent earnings and profit
2. Business stability with large-scale operations tends to make large-cap companies less volatile in comparison to mid-cap and small-cap companies. However, large-caps are not immune to market fluctuations; only the price volatility may be less extreme.
3. It is important to note that large-cap funds are not risk-free; they are only relatively more stable as they provide better downside protection in comparison to high-risk segments like mid-caps and small-caps. The prices can still decline during market corrections.

How Large Cap Funds Reduce Portfolio Risk?

Here is how large-cap funds can reduce portfolio risk:

1. Reduce Volatility in Portfolio

Since large-cap funds experience relatively less extreme price movements, they can smooth out the overall volatility by offsetting the sharp ups and downs of investments in small-cap and mid-cap funds.

For example, suppose your portfolio has 30% allocation to small-cap, 30% to mid-cap and 40% to large-cap funds. During a volatile market, the large-cap funds portion in the portfolio can provide a cushion against the impact of steep corrections in small-cap funds.

2. Provide Downside Cushion

Since large-cap funds have better downside protection, generally, price falls are less extreme in comparison to aggressive segments like small-caps and mid-caps. For instance, if small-caps fall by 25% to 30% during a market correction, large-caps may fall by 10% to 15%. This relative resilience helps in balancing the overall portfolio risk, especially during a market downturn.

3. Improve Risk-Adjusted Return

Risk-adjusted return is a measure of an investment’s profitability (return it can earn) relative to the volatility or level of risk taken. A portfolio that is heavily tilted towards high-risk segments may potentially generate a higher return during a bullish market and also suffer higher losses in a market downturn.

By adding large-cap funds to your portfolio, you can bring in consistency with reduced volatility in an uncertain market. This improves the risk-adjusted return for a long-term portfolio.

4. Act as a Portfolio Anchor

Large-cap funds provide balance and stability to your equity portfolio, acting as a foundation. A significant allocation to large-caps allows you to take a calculated exposure to aggressive segments without overexposing to higher risk.

How Much to Allocate to Large-Cap Funds?

The ideal allocation into large-cap funds may totally depend on your financial goals, time horizon and risk-taking ability.

1. If you are a conservative investor, you may go for a relatively higher allocation to large-cap funds, say 50% to 70%.
2. If you are a moderate risk taker, you may go for a fair allocation to large-cap funds, say about 30% to 50%
3. If you are an aggressive investor, you may allocate a smaller portion to large-cap funds, say about 20% to 30%, depending on your risk appetite.

The allocation may also vary depending on your goal. For instance, an investor approaching retirement may allocate more into large-caps than a younger investor who has a longer investment horizon to benefit from market volatility. The key to meaningful allocation into large-caps is the balance that reflects your ability to handle risk and return expectations.

How to Add Large-Cap Funds to Your Portfolio?

It is quite simple to add large-cap funds to your equity portfolio. There are multiple effective approaches to do so:

1. SIP Vs. Lumpsum Approach

SIP is ideal for most investors, from beginners to seasoned investors, as it instils discipline and averages cost and volatility. The lump sum approach requires careful research and can be a good option during market corrections.

2. Rebalancing Strategy

Regular rebalancing of the portfolio (once a year) can help you reduce the impact of market movements and bring the portfolio back to its intended structure.

3. Avoid Timing the Market

While investing in large-caps, investing for long-term goals and maintaining consistency would be better than timing the market for entry and exit.

Considering investing in established large-cap funds like Nippon India Large Cap Fund may bring stability to your equity portfolio, as they focus on long-term capital appreciation, seeking high-risk-adjusted performance.

Limitations of Large Cap Funds

While large-cap funds act as a portfolio anchor, they do come with certain limitations, such as:

1. They may underperform in a strong bullish market in comparison to mid-caps and small-caps that witness a sharp rally.
2. Limited potential to generate alpha (excess) returns
3. They are not ‘risk-free’ and see price decline in market downturn.

When Large-Cap Funds Work the Best?

Large-cap funds work the best in the following scenarios:

1. In a volatile market, it provides relative stability
2. Performance consistency of large-cap funds helps in steady wealth creation for long-term investors
3. Large-cap funds offer a balanced entry into the equity market, especially to beginners and conservative/moderate investors.

Conclusion

To conclude, return and risk are equally important when it comes to investing in the equity market. While aggressive segments like small-caps and mid-caps can potentially boost returns, the potential risk and volatility cannot be avoided. Hence, meaningful allocation into large-cap funds is extremely important to balance the risk-return equation. Adding stability and consistency can help you build a resilient long-term portfolio. A disciplined approach and right allocation into large-cap funds form a strong foundation for your equity portfolio.