Does a higher mutual fund AUM mean higher returns? Breaking the myth

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Suppose there are two equity mutual fund schemes – one has Assets under Management (AUM) of Rs 10,000 crore and the other has an AUM of Rs 3,000 crore. Which one would you invest in?

Many investors assume that a larger AUM means that the scheme is performing better than those with smaller AUM. But is it really so?

Does the size of a fund indicate its success? Or are the two – fund size and performance– independent of each other?

Is there a thumb rule with respect to these two variables that applies to all mutual fund schemes or are there a few exceptions?

In this blog, we will address all these queries and try to explain what really happens to a fund when it grows in size. We’ll also guide you on what you should consider before purchasing a mutual fund and when is ita good time to exit.

But, before we get there, let us first understand what makes the AUM go up.

What makes a mutual fund’s AUM increase?

There are two main factors…

1. Increase in the value of the underlying securities – The overall price of the underlying assets could rise from the price at which they were purchased and this causes a rise in the value of the entire portfolio (Read: AUM).

2. Increase in inflow of new funds – New investors may purchase units of the scheme and this positive net inflow of funds makes its AUM increase.

That brings us to the question: Does a mutual fund’s AUM affect its performance?

Over the last 2 years, Rs. 2.4 crores (appx.) have been pumped into Indian equity mutual fund markets. About Rs. 1 trillion has flowed into various funds every year in the form of Monthly Equated Installment of Rs. 8,000 crores (basically SIP investments).

Mutual funds

Surprisingly though, most of these investments came into mutual fund schemes with relatively large AUMs.

So, not surprisingly, the assets of top equity funds have grown by 50% in the last 2 years.

Mutual funds

This makes us wonder if investors have greater trust in mutual funds with higher AUMs.

Is higher AUM synonymous to better performance?

Many researchers and analysts differ in opinion.‘How Does Size Affect Mutual Fund Performance? Evidence from Mutual Fund Trades’, a paper by Jeffrey A Busse and few others, has used “a unique sample of actual fund trades combined with fund portfolio holdings to precisely pin down why larger funds underperform smaller-size funds”. The same report quotes that – “small funds outperform large funds by earning extra return premia from their holdings, characterized by lower market cap, greater book-to-market, and higher price momentum, on average”.

Fund managers, in many past instances, have also expressed the importance of controlling the fund size by closing the funds for further lumpsum investments once they reach an appropriate size. Few examples of these include Reliance Small fund, DSP Microcap Fund, Mirae India Emerging Business Fund and others, where it was important for the respective fund to be limited in its size to stick to its investment objectives.

What happens when a fund’s AUM grows?

A larger fund means more money to invest. Upto a certain limit, an additional sum of money can be invested in any of the stocks that fit into the fund’s investment strategy.

The problem only begins when the AUM gets larger than that. It is at this point that the fund manager may find it difficult to invest in stocks with lower market depth and trading volumes. Here, we are particularly referring to funds that invest in small, mid-cap and multiple-cap stocks.

When the size of these funds swell, the fund manager is usually unable to capitalize on the existing opportunities in small and mid-size stocks due to liquidity issues. As a result, the fund manager might…

  • Find it difficult to invest in promising stocks with lower market depth and trading volumes
  • Deviate from the investment objective of the fund and be forced to change his investment strategy
  • Spread the assets over a larger number of stocks because investing hefty amounts in one particular  stock may affect the share price (especially in case of small and mid-cap stocks with lower trading volumes)
  • Start holding higher amounts of cash
  • Gradually change the investment strategy (invest in funds that do not conform to the original investment mandate) and may witnesses a downfall in returns

However, this is not a standard road down which all funds go; there could be variations in their journeys, based on many other factors. For instance, when more money flows into pure large-cap funds, it is simpler for the fund manager to invest it into the blue-chip funds that trade in heavy volumes and enjoy a good market depth. Since doing this conforms to the large-cap fund investment mandate, size really does not affect their performance.

This is also likely to be true for index and bond funds. Since the market for bonds is far larger than the stock market, the price of bond funds is less sensitive to high-volume trades.

Thus, the effect of AUM expansion is, by and large, felt more on small-cap and mid-cap funds than any other.

Having inferred the above, is there any benchmark which indicates whether a fund’s AUM is well within healthy limits and will not affect its performance negatively?

Unfortunately, not. But there are certain other ways which can help you can figure this out.

Reality check for fund size

1. Risk

2. Liquidity

3. Investment strategy

Now that we have now understood the connection, or lack of it, between the fund size and investment potential, let’s look at when you should consider exiting a fund.

When to exit a mutual fund?

When the fund’s investment strategy changes – The investment strategy of a fund is the most important criteria to consider while selecting or exiting from a particular scheme. Investments are made with a certain objective. So, when the fund begins to move away from its originally disclosed investment strategy, it may be a good time to start looking for alternatives.

When your targets and goals are achieved– Of course, there’s another case, which is completely based on your unique financial plan. When you believe that the investment has met your goal, you could consider exiting. So, for instance, if you have been investing towards collecting a retirement corpus, when you decide to retire, you may shift your investment from the fund to an annuity.

So, all things considered, does a bigger AUM always mean laggard performance?

No, not always. Different funds behave differently as they start becoming bigger. Whether the size expansion comes across as an opportunity or a limitation depends on various factors, including the fund manager’s expertise, the type of scheme, investment objective, market condition, cash holdings, liquidity, investment strategy, trading volumes, etc.

You may also like: Is Investing in Small Cap Funds Really Risky?

Disclaimer:

We, Ventura Securities Ltd, (SEBI Registration Number INH000001634) its Analysts & Associates with regard to blog article hereby solemnly declare & disclose that:

We do not have any financial interest of any nature in the company. We do not individually or collectively hold 1% or more of the securities of the company. We do not have any other material conflict of interest in the company. We do not act as a market maker in securities of the company. We do not have any directorships or other material relationships with the company. We do not have any personal interests in the securities of the company. We do not have any past significant relationships with the company such as Investment Banking or other advisory assignments or intermediary relationships. We are not responsible for the risk associated with the investment/disinvestment decision made on the basis of this blog article.

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