Size doesn't matter, mostly

Inherently, the size of a mutual fund should not matter, and for the most part, it does not. However, this does run against a deep-set bias that investors have. When it comes to financial service providers (and many other businesses), customers like size. People seem to believe that a big shop, a big retail chain or a big newspaper will provide better goods or services. The underlying logic is that a business becomes big only if its customers are happy. This may or may not be true in all cases.

However, it's certainly far from the truth in the case of mutual funds. Investors often tend to 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 strong 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 that may be doing better.

Suggested read: How big is too big for a fund?

Does this idea have any actual validity? As it happens, Value Research data shows that compared to smaller funds, a relatively greater proportion of larger funds have good performance. However, this is not a strong trend and certainly not an inviolable one. There are still many lousy large funds and there are many great small funds. As an investor, you must not fall into the trap of confusing cause with effect. Remember, correlation does not imply causation.

Funds that have a long track record of good performance tend to get large as more and more investor money flows into them, and this money has a long time to grow. They were good, so they eventually became large. However, the opposite is not true. You can't pick a random large fund and say that just because it's large it must be good. Equally, you can't pick up a smaller fund with good performance and say that its performance does not matter and you must not invest in it because it's small.

Apart from good performance, there are many variables that can make a fund large or keep it small. In fact, the marketing prowess of a big fund company or the reach and clout of its parent among fund distributors are the biggest reasons. 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 to be very poor performers but they are still large.

More importantly, it is also the case that there are a number of relatively small equity funds in the fund 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 that a fund is small or a fund company does not measure 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 there are no circumstances under which fund size matters? There are, and interestingly enough, size can be 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 size. On the other hand, SEBI's recent rules changes mean that large funds have lower expenses and that itself can be a small boost to returns.

The bottom line is that while there are some factors that are affected by size, many others are not. All things considered, investors should mostly focus on track record and suitability to their investment goals.

Also read: Are the returns of big funds sustainable?