By Parthajit Kayal
Most individual investors who want professional management for their stock market investments place their money in mutual funds. However, the availability of too many mutual fund schemes makes the process of choosing the right mutual fund schemes quite difficult for retail investors.
Academic studies have shown that mutual fund schemes with lower funds or assets under management tend to perform better than the popular mutual fund schemes with a large fund under management. In this article, we discuss why it makes sense to go with small-sized funds.
Disadvantages of large-sized funds
Due to regulatory reasons, most big mutual funds must limit their ownership stakes to 5% or 10% of the total shares of a company. Therefore, it is difficult for large funds to buy enough shares of smaller companies. With this restriction, they end up buying large companies’ shares which are generally traded at a higher valuation.
Generally, investment options get narrowed down as a mutual fund scheme’s fund size increases.
For the large-sized mutual funds, there are only a relatively few investment opportunities that are large enough to make a significant difference to the overall investment returns of the mutual fund portfolio.
Further, mutual funds charge fees or expenses at around 1-2% of the investment value. This means bigger the size of the funds, bigger the size of funds’ profit. Fund managers get a decent share of it as a part of their salary, bonuses, and other incentives. Therefore, it gives more encouragement to raise the fund size instead of trying to generate better returns which play against the financial goal of the retail investors.
Advantages of small-sized funds
Small-sized funds have less competition from the big funds when searching for bargain-priced companies. They have thousands of more companies to choose from when making investment decisions (large-cap, mid-cap, and small-cap stocks). So having relatively small-sized funds is a great advantage in the investment world. Less competition and more choices are a real advantage.
Less-known, small-sized companies are often too small for large funds to invest into or to undertake research coverage. Most of the media houses also do not cover this kind of stock. These lead to less competition from the buyers which means greater opportunity to find bargain priced stocks that could potentially generate high returns in the future. Small-sized fund houses can take advantage of this opportunity by investing in less-followed small capitalisation companies.
Why and when does a fund lose its advantage?
The incentive system in the mutual fund industry is designed in such a way that expanding the size of assets under management becomes the primary goal for fund houses and their different fund schemes. Already successful mutual fund schemes that have generated good returns in the past become popular in the media and among the investors. It helps the funds to attract a large pool of money. However, once these funds grow into a very big size, they can no longer take advantage of some of these smaller investment opportunities.
Instead, they end up over-diversifying their portfolio by investing in many overvalued large-capitalised companies.
Over-diversification leads to poor results. Further, it is generally more difficult to manage larger sums of capital. When a fund is smaller, it can take advantage of some smaller opportunities. A larger universe of stocks to select from gives a manager more chances to find bargains.
It may be wise for retail investors to choose relatively new and smaller-sized mutual fund schemes for their investment. In recent years, there has been a sudden advancement in the wealth management industry due to digitalisation, e-KYC facilities, etc. Many new and small-sized companies got licenses to offer mutual fund schemes. For more informed decisions, they should also check the track records of other funds (if any) offered by these small-sized fund houses and also the track record of the fund managers.
The writer is assistant professor, Madras School of Economics