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7 reasons why mutual fund size matters... a lot

It is often a matter of debate whether the corpus size of a mutual scheme — AUM (Assets Under Management) in MF lingo — has a bearing on its returns or not.

To arrive at the right conclusion, one must appreciate the fact that investing is not an exact science. Ten people, given the same set of stocks, will deliver ten different results.

In other words, in the real world of investing, things don't happen in the textbook manner where the inputs and their outcomes follow a standard rule.

Given this uncertainty in investing, let us explore why there is a high probability of the size of the mutual fund having a significant impact on its returns. And, this being further corroborated by history too.

1. It is but natural that large funds attract and can afford to employ the best of talent. With good fund managers and good research team behind it, a large fund definitely has an edge over a small fund.

2. It is human tendency that large funds get more-than-adequate attention of the management than a small fund. Small funds could get neglected.

3. As the fixed costs get spread over a large base, large funds typically have lower expense ratio or the annual fund management charges. Simple calculations would show that, due to compounding, even a small difference of 0.5% in expenses will have huge impact on the corpus you will take home say over a period 7 to 10 years. This aspect is particularly more critical in debt funds, where the returns are typically in single digits and hence even small savings in expenses will be quite rewarding.

4. Diversification is one of the key advantages that a mutual fund offers. Due to limited availability of funds, small funds may not be able to adequately diversify their portfolio. Thus higher concentration in a small mutual fund may defeat the very purpose of investing in it.

5. Small funds have to either maintain higher percentage of cash holding or sell their investments in distress, if and when there is a redemption pressure. Large funds can better withstand such difficult times.

6. Of course, "too large" a fund has its own issues. A fund's exposure per company cannot exceed the prudential norms. Too big a corpus would, therefore, translate into too many companies in the portfolio. This unwieldy portfolio may not be easy to manage, resulting in a possible dip in the performance.

7. Moreover, not all situations favour a large fund. Take for example the sector funds or even the mid-cap funds. The investment space here is limited. So a large sized mid-cap / sector fund may not find enough opportunities to suitably deploy its entire capital. Besides, even small transactions in a medium-sized company could distort its share prices. Here, an average-sized fund (which is neither too big nor too small) has better chances of delivering better returns.

And this is clearly evident from the 20+ years of the history of mutual funds in India.

If you compare the performance of funds on any given day, you will often see small funds (size less than Rs.100-200 crores) among the top performers. Naturally, investors are attracted by their superlative performance. And this is where they often go wrong.

If you now compare the performance across different dates, you will rarely find the same set of small funds among the top performers. But you will see many common names of big funds (size more than Rs.1000 crores) among the best performers.

Past experience, therefore, shows that when it comes to "consistency", big funds are any day a better bet than the small funds. Since same small funds rarely appear among the top performers, why place your money where the odds of winning are low?

In short, stick to big equity funds. Small funds will shine for some time, but then disappear. Big funds will make money for you with more reliability.

Another example that size does matter is the fact that, prominent mid / small-cap funds have closed their scheme for subscription for time to time, whenever it became difficult for the fresh inflows to be invested profitably. 

Concluding, I would say that don't think in terms of big-size or small-size, but rather as right-size or wrong-size. Do this, and you won't go wrong with your fund selection.

By the way, size is not an absolute number. India is a growing economy. Therefore, as the size of the economy expands, definition of the "right-sized fund" too will change. A decade back Rs.5000 crore fund may have been a large fund. But today it would get classified as a medium-sized fund.

Very Important : Before I end this discussion, here is a warning... size is just one of the many factors to consider. So don't base your investment decision purely on the fund's AUM.

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