Size is something that always makes us feel more comfortable and trusting about anything, especially when we invest our money. When people see a fund that manages millions of crores of capital, it is almost natural to assume that it must have better returns on its assets than other funds with less invested capital.
However, recent research shows that the size may not be an indicator of a better return performance. On the contrary, Indian equity mutual funds, which are among the largest in India and whose assets reach millions of crores, show disappointing results when it comes to returns.
Growth of India’s Equity Mutual Funds in Terms of Their Size
India’s mutual funds have grown exponentially over the last years, and now there is a significant number of retail investments made via systematic investment plans (SIP). The result is that some equity funds accumulate huge amounts of assets, which sometimes reach the size of 50 thousand crore.
It is characteristic of large-cap, flexi-cap, and index funds because of their high popularity and size. But what is the connection between their asset base and their returns?
Why Are Big Funds Appealing?
Bigger funds enjoy a number of benefits. First, they are stable investments since they have diversified portfolios and sound risk management policies. Second, they have advantages related to economies of scale. The operational expenses of such funds are usually relatively low because each investor bears fewer expenses.
Third, the managers of bigger funds are usually professional investors supported by sound research. It helps build trust with new investors who will follow suit. Therefore, there is a cycle of fund growth.
Still, at a certain point, a bigger size brings its problems.
The Pitfall of Being Big
Managers of bigger funds find it difficult to manage an extensive portfolio. There are restrictions concerning buying smaller- and medium-cap stocks without moving market prices. Consequently, big funds may be forced to keep only large-cap stocks in their portfolios.
Such funds suffer from liquidity constraints when they cannot buy more stock shares because there are insufficient buyers. It is the reason why a large-cap fund cannot bring better results for its owners compared to a small-cap one.
The latter can invest in emerging sectors that provide high growth, but it is connected with higher risks.
What the Data Shows
There is no conclusive evidence from data on India’s largest equity mutual funds to show that a mutual fund that is larger is capable of performing better. On the contrary, most of these funds have been found to provide returns that are almost similar to benchmark indexes without exceeding them.
This is especially true for large-cap funds since they operate within a limited pool of stocks. This makes differentiation difficult and the returns converge.
Nevertheless, there are mid-cap funds that have managed to generate superior results thanks to their agility and flexibility in choosing stocks.
It should be noted that while size may not necessarily be an indicator of performance, consistency may play a significant role in determining whether a mutual fund is suitable for conservative investors.
The Role of Diversification
Diversification is another key consideration. Larger mutual funds normally own stocks from diverse sectors. Although this lowers risks, it may lower returns.
For instance, even when certain stocks record exceptional returns, their contribution to the entire portfolio may be insignificant considering the massive size of the mutual fund.
This cannot be the case for smaller mutual funds since they may invest heavily in certain stocks in the hope of high returns.
Behavior and Perception of Investors
The psychology of investors influences the formation of big funds. Most investors perceive size as strength, implying that the risk of loss will be lower in the case of a fund of bigger size.
Apart from that, popular fund managers with high assets under management benefit from good brand recall, which draws more investments.
However, investors should not necessarily pay heed to size but to the following parameters instead:
1. Experience of fund manager
2. Strategy
3. Return consistency
4. Performance based on risk
A Fund Size That Benefits You
Size, although challenging in some ways, is not necessarily a weakness. For some types of funds, such as index funds and ETFs, bigger size is an advantage.
They follow index returns; thus, the selection of stocks is not required. Also, the bigger pool makes tracking better and lowers the cost.
Moreover, during market instability, size can serve as a cushion against losses because of diversification.
Finding the Right Balance
What should be kept in mind is the fact that the answer cannot be a generalized one. Big funds mean safety and low risks, whereas smaller funds bring along growth opportunities and maneuverability.
For any investor, what seems to be the best strategy is finding the right balance. A diversified portfolio will incorporate various sizes of funds in order to achieve a favorable risk-return tradeoff.
Conclusion
As much as the perception that bigger mutual funds are bound to generate higher returns has been proven wrong, it is important to know that bigger funds are not necessarily less effective.
As a matter of fact, when looking at the current scenario of the financial market, an investor should take into account many other aspects rather than AUM.
