Does AUM Size Affect Mutual Fund Performance? Here’s What You Must Know…
Jul 10, 2018

Author: PersonalFN Content & Research Team

Here’s a subject most fund managers are reluctant to speak about. The sole reason is that the asset size of the fund drives their earnings. Some may shrug it off on the basis that there is no correlation.

However, the effect of the fund size of mutual fund performance is a growing concern, especially in light of massive inflows that have increased the mean size of funds in the recent past.

Over the past three years, investors have dumped over Rs 3 lakh crore of assets in the hands of equity mutual fund managers. The total AUM managed by equity-oriented funds has more than doubled to Rs 7.41 lakh crore in May 2018, from Rs 3.65 lakh crore in May 2015.

Rising Equity Mutual Fund Inflows

Data as on July 9, 2018
(Source: ACE MF, PersonalFN Research)

Over the same period, the assets under balanced funds grew by over six times to Rs 1.78 lakh crore from Rs 0.29 lakh crore.

Most of the assets are skewed to the top mutual fund schemes. The top 25 schemes as per AUM, out of the 257 equity-focused schemes, accounted for over 50% of the total industry assets.

Assets of Top Equity Funds Have Doubled In Three Years

Data as on July 9, 2018
(Source: ACE MF, PersonalFN Research)

This clearly indicates, investors are focused on larger sized funds. But, is big always better?

Understanding the effects of the fund size on fund returns is an important step. In the Indian context, given its short history and small sample size, the statistics to prove that the mutual fund performance deteriorates with fund size is negligible.

Survivorship bias is another factor that taints the analysis. Fund houses tend to merge underperforming schemes with their better counterparts. Hence, the funds in existence usually show better performance when compared to other existing schemes.

Thus, we shift our focus to other research studies conducted in international markets.

A research paper titled, ‘How Does Size Affect Mutual Fund Performance? Evidence from Mutual Fund Trades’, authored by Jeffrey A. Busse, Tarun Chordia, Lei Jiang, and Yuehua Tang analyzed actively managed funds in the United States (US), using a database free from survivorship bias.

Their study reveals that though large-sized funds (not to be confused with large-cap funds) benefit investors with lower costs, they tend to underperform smaller sized funds due to their portfolio holdings. The primary reason is that large-sized funds tend to invest in larger market-cap stocks due to liquidity constraints. Their holding period in the stock also tends to be longer than smaller-sized funds.

Clearly, smaller sized funds (not to be confused with small-cap funds) are able to access a wider variety of stocks as compared to their larger counterparts.

Another research paper titled, ‘Does Fund Size Erode Mutual Fund Performance? The Role of Liquidity and Organization’, by Joseph Chen, Harrison G. Hong, Ming Huang and Jeffrey D. Kubik ends with a similar conclusion. They find strong evidence that “fund size erodes performance”. They found the deterioration in returns more prominent in funds that initially included an exposure to mid-and small sized stocks.

Big funds can compete by charging low expenses, whereas small funds have the opportunity to earn higher investment returns. If the performance of the larger fund is unable to satisfy investors, assets may flow out to smaller sized funds.

How Do These Findings Affect The Way You Pick Mutual Fund Schemes?

(Source: unsplash.com)

When a fund has an enormous asset size, its fund manager may have trouble maneuvering in and out of positions and investing in certain securities with lower trading volume or smaller market-caps. But the degree to which asset size affects a manager's ability to do his or her job depends on the type of fund and strategy its fund manager employs.

Pure large-caps funds may not witness a sharp deterioration as their fund size increases. Such funds usually adopt a buy-and-hold strategy, investing in top quality blue-chip companies. As expected, larger funds tend to hold more liquid stocks than smaller funds, since larger funds deliberately avoid stocks with insufficient liquidity. Hence, the growth in AUM of such funds rarely affects the risk-return potential.

The problem arises with funds that invest across market-caps. A small fund can easily put all of its money in its best ideas. Unfortunately, liquidity concerns forces a large fund to invest in its not-so-good ideas and take larger positions per stock than is optimal, thereby eroding performance. Research findings suggest that liquidity is an important reason behind why size erodes performance.

Given the burgeoning size of some equity funds in India, it is best to assess whether or not the AUM growth is causing changes to the investment style. Some changes may be in the interest of the investors while others may not. Act before any changes materialise into a disappointing performance.

Achieving historic super-normal returns may be difficult with an altered investment style. So, take a deeper look and stick to your fund if you are comfortable with the new investment mandate and ready to tone down on your return expectations. Else, move out.

At PersonalFN, we follow stringent research processes that focus on both quantitative and qualitative parameters to offer you a selection of solid schemes with the potential to generate 'market beating' returns.

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Remember, your hard-earned money is invested in mutual funds to create wealth. Choose wisely.