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How does an increase in a small-cap fund's size impact its performance, and is there a limit to how large it can grow before returns suffer? - Anonymous
When small-cap funds grow larger - often due to strong performance attracting more investor money - they encounter unique challenges.
However, this doesn't make them a poor investment choice. It simply means investors should understand the hurdles these funds face as their size increases.
What are the typical challenges faced by a larger small-cap fund?
1. Limited investment opportunities and liquidity constraints: Small-cap funds often invest in companies valued at around Rs 1,000-2,000 crore. For a fund managing Rs 100-200 crore, taking meaningful positions in such companies is relatively straightforward. But as the fund size grows, achieving similar exposure becomes challenging.
For example, let's say a small-cap fund managing Rs 200 crore wants to invest 5 per cent of its portfolio, or Rs 10 crore, in a company valued at Rs 1,000 crore. Buying shares worth Rs 10 crore is manageable without significantly impacting the stock's price or market liquidity.
Now, if the fund grows to Rs 2,000 crore and still wants to maintain the same 5 per cent allocation, it would need to invest Rs 100 crore in the same company. For a company valued at Rs 1,000 crore, this means the fund would need to own 10 per cent of the company—a much larger and less feasible position.
Additionally, finding enough sellers to buy such a large quantity of shares becomes challenging, and selling later could cause the stock price to drop due to low trading volumes.
2. Risk of over-diversification and dilution of returns: To avoid liquidity challenges, fund managers of larger small-cap funds are often compelled to buy more stocks. While this reduces the risk of any single stock affecting performance, it can dilute overall returns, as managers are forced to spread investments thinly or include lower-quality stocks in the portfolio.
3. The 'winner's curse': Exceptional performance by a small-cap fund often attracts significant inflows from investors, further increasing its size (also known as assets under management). Ironically, this success can hamper future performance, as the fund's size limits its ability to maintain its high-conviction strategy. If the fund underperforms, it fails to attract inflows, creating a lose-lose scenario.
How large should a small-cap fund be?
There is no specific threshold or proven number that determines when a small-cap fund becomes too large to manage effectively. The tipping point varies from fund to fund, depending on the manager's strategy, market conditions and the availability of suitable investment opportunities.
What should you do?
A growing small-cap fund isn't necessarily a bad thing and shouldn't discourage you from investing.
That's because such funds have different ways of tackling this issue. They often stop fresh lumpsum or SIP inflows. At other times, they adjust strategies to maintain focus on high-conviction ideas as a way to manage growth.
As an investor, look beyond the fund's size (AUM). Instead, focus on the fund's performance consistency, transparency of its strategy and the fund manager's track record.
Also read: Size doesn't matter, mostly
This article was originally published on January 08, 2025.
Disclaimer: This content is for information only and should not be considered investment advice or a recommendation.
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