Investors love large funds, but worry when they become mega funds. But these funds have their plus points, too
03-Jun-2019 •Aarati Krishnan
Indian mutual fund investors have a strange love-hate relationship with large-sized funds. While choosing equity schemes, many of them ardently look for safety in numbers. They screen for schemes with the largest assets under management (AUM) in a category, even before they take a look at their performance metrics. But surprisingly, the same investors also fret about size the moment their fund crosses Rs 10,000 crore in AUM. When a scheme scales up to the mega-fund category, every short-term blip in its returns is analysed, debated and discussed threadbare, with investors constantly asking if they should exit because the fund is now too big to succeed! Such fears have worsened in the past year, as active managers in general have had great difficulty beating the indices.
Thanks to this investor tendency to make a beeline for big funds, the large schemes in the Indian market have got steadily larger in the last few years.
You may be surprised to know that the top three funds in the large-cap equity category today hog nearly 40 per cent of the total category assets. In the multi-cap category, which features 50 odd schemes, the top three corner 33 per cent of total AUM. The mid-cap space, with two dozen schemes, is even more concentrated, with the top three schemes managing 48 per cent of the money.
Thanks to the mammoth assets under their belt, the mega funds are the ones that decide the investors' return experience. Value Research has consistently held the view that size shouldn't be your primary reason to either buy or avoid an equity fund. Over the years, we've observed no direct correlation between size and performance in the Indian context. There are many equity funds that should be on your buy list for their great performance, even though they're midgets in their category.
There are also many mega funds which remain top-of-mind choices in their category because of their managers' ability to hop, skip and jump ahead of the markets. Mega funds have both pluses and minuses as discussed below.
Size is a minus...
As equity funds grow in size, the two key factors that work against them are the lack of depth and liquidity in stocks. Today, the Indian market features over 5,000 listed stocks with a market capitalisation of Rs 151 lakh crore. While these numbers may look great when measured against the total AUM of about Rs 10 lakh crore managed by domestic equity funds, the ground reality is that the Indian investible universe of stocks is a small fraction of these numbers.
Seasoned investors know that this universe of 5,000 stocks is dominated by poor-quality names, with only 250 to 300 companies meeting the basic investment filters on profitability, shareholder returns and cash flows. Therefore, mega funds, which get flooded with inflows, may be forced to stray beyond their high-conviction bets to own some sub-par names in their portfolio, while small funds can run more concentrated portfolios.
Liquidity is the bigger issue, dropping off sharply the moment one goes beyond the top 150-200 stocks by market capitalisation. To illustrate, a fund with an AUM of Rs 15,000 crore, seeking to invest 5 per cent of its money in mid or small cap, will have to buy nearly Rs 750 crore worth of that stock in the market. Purchases of that magnitude are impossible to make without sharply bidding up the price of a mid- or small-cap stock. If building up positions in good mid or small caps in a rising market is hard, liquidating them in a bear phase can be nearly impossible. The liquidity and impact-cost factors can make it difficult for a mega fund to both build and exit portfolio positions, reducing the manoeuvrability of its portfolio.
In practice, mega funds usually cope with these constraints by upping their allocations to large-cap stocks and cutting back on their mid- and small-cap exposures. They also tend to add to the number of positions they hold to ensure easier entry and exit, and end up owning more diversified portfolios with long tails. These portfolio shifts do make it more challenging for large-sized funds to deliver alpha over their smaller-sized peers.
But there are mitigators
Having said this, many mega funds have proved quite adept at navigating these challenges by making strategic shifts to mitigate the impact of size on their performance.
One, large & mid-cap, mid-cap and small-cap funds beyond a certain size often use the leeway allowed by SEBI to allocate a material portion of their portfolios to large-cap stocks that take care of their liquidity needs. SEBI's categorisation rules allow mid-cap and small-cap funds to own up to a 35 per cent exposure in large-cap stocks and large- & mid-cap funds to park up to 65 percent in large caps. Larger funds in the mid- and small-cap categories also gated their funds to lump-sum investments in the recent bull market to regulate flows and manage the size problem.
Two, seasoned mega fund managers tend to get over the liquidity problem by buying and holding their stocks positions for long periods, reducing the need for them to suffer impact costs while building or exiting positions.
Three, big funds which follow value or contrarian strategies also find that size isn't that big an impediment. By not chasing fancied stocks in the market and by buying out-of-favour ones ahead of everyone else, they get to sidestep impact costs by accumulating stocks that everyone's selling.
Four, SEBI's latest crackdown on total expense ratios (TERs) of equity schemes also hands investors in big funds a sizeable advantage over their counterparts in small funds. Under SEBI's new slab structure for TERs, which kicked in from April 1, equity funds with an AUM of less than Rs 750 crore can charge up to 2-2.25 per cent a year by way of TER. But as fund sizes scale up to beyond Rs 10,000, the TER limit shrinks sharply to 1.50 per cent or lower. Effectively, the mega-fund category now has a 50-75 basis-point advantage over a midget fund on annual costs, which can make a big difference to investor returns in the long run.
Finally, one of the key metrics that we always ask investors to look for when choosing their equity funds is its performance across multiple market cycles. With the open-end structure, a fund which successfully weathers multiple ups and downs in the market often becomes popular with investors and amasses assets. Yes, on occasion, such mega funds do trip up. But in the majority of cases, if you hunt for a seasoned fund with an experienced manager, you automatically end up with a fairly large-sized fund.