Aum Size And Returns: What's The Relation And How To Evaluate

With the strong inflows in equity funds, the mutual fund industry has been buoyed by the rising assets under management. These rising inflows led to creation of many funds having huge assets under management (AUMs). So, what do funds with higher asset sizes mean to an investor? Does higher AUMs result in better performance? The investing fundamentals suggest that investors should invest in funds that are neither too small nor too big in size. So, let us find out if a fund’s AUMs swell, will it create a problem for its performance? 

To understand this aspect, one should be familiar with the concept of AUMs. Assets under management (AUMs) mean total market value of assets that an asset management company manages. The AUM of a fund indicates the size of the fund. AUM fluctuates daily, based on the inflows and outflows in the schemes as well as the performance of the assets held by the schemes. So, increased investor flows, capital appreciation and reinvested dividends will increase the AUM of a fund, and vice versa. The mutual fund industry has witnessed a huge growth in AUMs of more than 20% in the last one year. The mutual fund industry at the end of May 2018 has deployed assets of around Rs 22.60 lakh crore. In the last 10 years, the mutual fund industry has witnessed four-and-half fold increase in the AUMs. 

Many a times, investors think that mutual funds with larger AUMs are better bets than the ones with smaller AUMs. But is it so? . The normal argument that goes in favour of this is that a large fund enjoys some cost benefits. This is because whenever the fund grows, the costs related to the fund becomes lesser on a proportionate basis, which further improves the efficiency of the fund. 

Our analysis, however, shows that this is strictly not the case and funds with small AUM sizes also have lower expense ratios. Below are some of the equity funds from different categories and with different sizes, along with their expense ratios. It clearly shows no direct relation between the fund size and expense ratio.

The above funds with the highest AUMs in the category are not the best performers. So, this indicates that the fund which is larger in size does not reap highest returns every time. So, if that is the case, why do funds grow or attract inflows if they cannot generate returns better than a small-sized funds? To understand this, we have analysed the facts with the help of AUM and NAV data of funds for the last 10 years. 

We have analysed various equity funds from various categories which have given good returns over a period and, at the same time, witnessed good AUM growth over the period of time. The analysis shows that before reaching an inflexion point of the AUM, a fund generates steady returns with every rise in its AUM, but after that point, although the AUM grows, the returns start declining. Below is the scatter chart showing the relationship of the AUM growth and the returns.

The reason for such strange relation is that up to certain point as the fund performs well, it attracts more investors and enjoys the growth in AUM. This leads to large amount of cash flowing into the fund for investment. But to invest the cash as soon as possible and in avenues that generate returns better than or equal to the existing investments is a challenging task for the fund manager. Some of the fund managers may consolidate the money into their best bets, while some others may prefer to be on the safer side and keep the money idle. This starts hampering the performance of the fund. 

It is difficult to determine exactly at what point this can occur as the it may differ from one fund to another and may depend on the the fund managers calls; but in general, when the fund manager is incapable of maintaining the fund's investment strategy and generate returns and alpha comparable to the fund's historical record, the fund has become too large.

However, it should be noted that the case is opposite in the case of index and ETFs. Here, the size is not a problem in both these cases, as bigger is definitely better. As the portfolios of these funds are just a replica of their respective benchmark index, it follows that the portfolio management is easily handled and, with the rising AUMs, the funds' operating expenses get spread over a larger asset base, which further reduces the fund's expense ratio, thereby helping it to reap higher returns.

According to the conventional investment wisdom, the size of the fund should be comparable with the investment style of the fund and the universe of stocks available for investment. For instance, if a large-cap fund grows unexpectedly with the investment style and its universe, the fund's portfolio may get overdiversified or concentrated, and both these eventualities may result in deterioration in the returns for the investor. So as far as the diversification is concerned, funds with larger or smaller AUMs are not reliable. 

So, like in the traditional story of the Goldilocks and the three bears, where Goldilocks finds the right bowl of porridge, just like that, the investor needs to find the schemes with the perfect AUMs, neither too large, nor too small. This is because too large a fund may deliver lower returns, while too small fund may run a huge risk. So, while selecting a scheme, you can follow three simple checks for the AUM. 

First, consider the size in relation to the investment style of the fund. That is, one can easily consider the average AUM of the particular category of the fund and invest in a fund which has AUM below that average. Second, investors should look into the past cash holdings and performance of the securities of the fund as a shrinking asset base can be an indication of the decreasing fund size or poor fund management. Third, and the last, is evaluating the current cash holdings. Many a times, when fund managers find it difficult to allocate investment according to the investment objective, the fund may have high cash holding, which can further affect returns. The only exception to this will be the case where the fund manager takes a call of holding more cash in anticipation of a market decline in order to pick up the value stocks. 

The bottom line is, as AUM of mutual fund scheme grows exceptionally high, it can hamper the performance of the fund so investors should always keep an eye on the AUM growth of the fund and should always evaluate its benefits and risks.