Are small funds better than large ones?

- Irfan

You have definitely raised a noteworthy point.

A large size can be a cause for concern, particularly for mid- and small-cap funds. Here are some issues that large-sized funds face.

1. With huge amounts to invest, there is always the need to scout for more and more attractively priced stocks.

2. A large fund size can lead a fund towards over-diversification (investing in too many shares). Because even if they invest huge sums of money in particular stocks, it will form only a miniscule part of the overall portfolio. This, in turn, will impact performance since exceptional returns of a few stocks tend to get diluted and averaged out in a huge portfolio. For instance, if you have 15% of your total investments in Company A and it gives a 75% return, it will make a substantial difference to your overall returns. But, if you have just 5% in that company, then the impact will be less.

3. A large size tends to make the fund less agile.

Take the case of Franklin India Prima, a mid-cap fund managed by some of the finest brains in the mutual fund industry today.

The fund's large size was cause for concern. It was due to the large size of the fund that Franklin India Prima opted to close fresh investments for some time. It is difficult to invest huge amounts in good mid-caps without affecting the price too much.

Let's say a fund is managing Rs 1,500 crore (Rs 15 billion) and wants to invest just 5% of that in one stock. Let's say the market capitalisation of that stock is Rs 1,500 crore. This one fund will then own 5% of that stock.

If the fund decides to buy such a stock, the price will shoot up. If the fund wants to sell the stock, the price will come crashing down because the fund has such a large holding in that stock.

After all, stock prices change in relation to how much money is chasing them.

Smaller funds tend to be nimbler, which enables them to easily take buy or sell stocks or shuffle those in their portfolio.

For example, a Rs 50 crore (Rs 500 million) fund can easily offload Rs 1 crore (Rs 50 million), which is 10% of its net assets, without having any significant impact on the markets. But the same may not be possible for a Rs 500 crore (Rs 5 billion) fund.

In the case of the latter, the fund manager might be forced to sell the stock over a few days so as not to impact the share price too much.

The above liquidity problems are frequently associated mid- and small-cap stocks. A big fund might find itself stuck with a sizeable holding in a mid-cap stock from which it is unable to exit quickly. Large-sized funds can particularly find themselves prone to such a situation when markets suddenly turn sour and there are no buyers for the stock.

While these are the problems faced by large-sized funds, one cannot conclusively say that small-sized funds are doing better than their large-sized counterparts within the same fund house.

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