Should you invest in a active small-cap or mid-cap mutual fund scheme with a high AUM?

we explore the implications of substantial AUMs for both passive and active funds in the context of finance

Suppose you're stepping into a new restaurant, enthusiastically recommended by your close friend. However, as you peruse the menu, you find yourself at a culinary crossroads, unsure of which dish to select. In such a scenario, you may lean towards ordering the bestseller—the dish that has been savored by a higher number of patrons. After all, its popularity among diners is often a strong indicator of its delectable taste and overall appeal.

Can this same rationale be applied when selecting equity funds? In the realm of equity funds, a similar principle can be employed by examining the assets under management (AUM). Does a larger AUM equate to superior investment returns?

In this article, we explore the implications of substantial AUMs for both passive and active funds in the context of finance.

Is the concept of scalability equally applicable in all strategies?

Let's first examine passive funds, such as index funds and exchange-traded funds (ETFs). These funds are designed to replicate the performance of a specific benchmark index. A key factor to consider is that these funds can only invest in assets that are part of their benchmark index.

The return on an index fund closely tracks the benchmark return, with adjustments made for expenses, often referred to as the total expense ratio (TER). Notably, larger fund sizes tend to be associated with lower TERs. Consequently, a substantial AUM can be advantageous for an index fund, allowing it to achieve returns that closely align with the benchmark due to the reduced TER.

ETFs, too, can benefit from significant AUM. A larger AUM means there are more units available for trading in the market. This leads to higher trading volumes, resulting in narrower bid-ask spreads. A reduced spread signifies improved liquidity. The higher the liquidity of a traded security, the greater the likelihood of executing transactions at the last traded price, thus minimizing slippage costs.

But when it comes to active funds especially in the Mid-Cap and Small-Cap, the picture becomes more nuanced.

The primary objective of investing in an active fund is to generate alpha—excess returns beyond the benchmark index. Consider a scenario where a mid-cap or small-cap active fund experiences a surge in capital inflows due to its impressive performance. The portfolio manager may face the challenge of investing this influx of capital in a similar set of stocks. However, these stocks may have appreciated in value, reducing the potential for generating alpha.

It's crucial to understand that the scalability of the alpha strategy is not universal. What works effectively for an AUM of, let's say, Rs 5,000 crore may not yield the same success with an AUM of Rs 10,000 crore. The net asset value (NAV) growth of a mutual fund reflects only the gains realized by the fund.

For a more concrete illustration of the impact of AUM size, consider a small-cap fund. Suppose it manages assets totaling approximately Rs 250 crore and intends to allocate 5 per cent of its corpus (Rs 12.5 crore) to a small-cap company with a market capitalization of, let's say, Rs 800 crore. Executing this allocation is relatively straightforward due to its proportionate size compared to the company's market capitalization.

In contrast, if a larger fund, with assets worth Rs 6,000 crore, seeks a 5 per cent allocation (Rs 300 crore) to the same small-cap company, executing this allocation efficiently becomes challenging. The Rs 300 crore allocation looms significantly larger in comparison to the company's market capitalization of Rs 800 crore. This situation incurs an impact cost that could substantially inflate the stock price of the company, rendering the entire investment endeavor unworthy of pursuit. Moreover, divesting such a substantial stake in the company may prove equally daunting.