Size doesn't matter

There is a common belief that bigger funds are better. This is not true and following this could lead to poor investment decisions

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People seem to instinctively believe that a huge shop, a massive retail chain or a big newspaper will provide better goods and services. Presumably, the underlying logic is that a business becomes big only if its customers are happy. This may or may not be true for all cases.

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However, this logic is far from the truth in case of mutual funds. A lot of investors believe that the size of a mutual fund is important. In this context, size means the amount of money that a fund manages. This belief has no real basis. There's no inherent reason that a larger fund is better than a smaller one. If a smaller fund has a better track record than a larger fund of the same type, then by all means investors should choose the smaller one. Of course, investors hold this belief not just because of the 'big is good' presumption, but because it is actively promoted by the sellers of larger funds as it gives them an additional handle to promote their fund against some other smaller ones which may be doing better.

Does this idea have any actual validity? As it happens, Value Research data shows that compared to smaller funds, a relatively bigger proportion of larger funds have good performance. However, that's a small and very diffused trend. There are many lousy large funds and there are many great small funds in India. As an investor, you must not fall into the trap of confusing cause with effect. Funds that have a long track record of good performance tend to get large as more and more investor money flow into them and this money has a long time to grow. They were good performers so they eventually became large.

Is the opposite true from the point of view of an individual investor's choice of a fund? You can't pick a random large fund and say that just because it's large it must be good. Similarly, you can't pick up a small fund with a good track record and say that its performance does not matter and you must not invest in it because of its size. Apart from good performance, there are other variables that can make a fund large or keep it small. In fact, the marketing prowess of a big fund or the reach and clout of its parent among fund distributors are the biggest reasons for a fund to grow in size. There can be other factors too. For example, there are a number of equity funds that started out large on Day One because they had hugely hyped NFOs at the peak of the markets. Some of these have turned out be dampers although they are still large in size.

It is important to note that there are a number of relatively small equity funds in the industry that have displayed good long-term performance and are definitely worth a look. Whenever an investor wants to invest in such a fund, or when an analyst like me praises them, those selling larger funds dismiss the idea contemptuously. 'But you can't compare a Rs 5,000 crore fund to a 500 crore one!' they protest. This is a red herring. To the investor, it is irrelevant whether a fund is small or if a fund company is not high up in the fund industry's pecking order. If a fund has a good track record and a high rating from Value Research, then size doesn't matter.

Does that mean that are there no circumstances under which fund size matters? There are, and interestingly enough, size is a disadvantage for some types of large equity funds. For example, funds focussing on small and mid-cap stocks may not be able to find enough stocks that they can invest in. During negative phases of the stock markets, these funds may suffer a double whammy of rapidly declining values as well as poor liquidity. Both the upside and the downside are an integral part of investing in smaller companies--it has no inherent connection to fund the size.

The bottom line is that if you think (or if someone is telling you) that one fund should be preferred over another on the basis of size alone, then that could lead you to take some poor investing decisions.

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