How big is too big for a fund?

Dhirendra, when a fund becomes very big, its investors wonder whether it continues to be investment-worthy. What's your view on this?
Dhirendra: The answer to whether funds which grow big remain investment-worthy is both yes and no. The answer is 'yes' because a mutual fund is a business of scale. In most cases, the bigger, the better. But there are some exceptions to this. For instance, there are many strategies that work well only when the size of a fund is small. If it turns big, the same strategies fail.

When it comes to large-cap funds, Exchange Traded Funds (ETFs) and debt funds, the bigger the better, as a larger size enables you de-risk yourself to a greater extent. Now SEBI has also made a provision whereby if a fund gets bigger, it has to charge lower expenses. This way you enjoy economies of scale.

In which cases does the size of a fund matter? And what is the ideal size?
Dhirendra: Size does matter in some cases. When it comes to actively managed funds, getting very big means that it gets difficult to manoeuvre.

But just think of an index fund or an ETF where it has to do nothing, as it is in the business of simply replicating the index. The popular indices in India invest only in large companies, and large companies have enough liquidity. There's one exchange-traded fund that tracks the Nifty 50 index which has actually become a Rs 51,000 crore fund. But I don't think it is going to be a problem because it can well be run.

You would be in trouble if the underlying assets in which the fund is supposed to invest is not liquid enough. It then ends up buying something which is not liquid enough and when it wants to sell it, it is stuck. That is not the case with Nifty 50. There is no liquidity issue. But yes, it still has to be tested.

Similarly, I don't think there is any problem with scale in case of a liquid fund. We have seen a big liquid fund worth Rs 80,000 crore and it was good. It was safer. It also had economies of scale going for it.

I would say that most of our actively managed equity funds are still far from achieving a scale where it becomes a deterrent to their performance. As for index funds and those mechanical funds, I don't think there is a liquidity issue.

Also, SEBI has recently differentiated expenses for bigger funds. Effective 1st of April, investors in these big funds now get an advantage of scale as the expenses charged are lower. And this difference should translate into something meaningful over a long period of time. So when these funds get big, investors will benefit.

So what you are saying is that in this scenario you get the advantage of lower costs without any compromise on liquidity. Also, I was looking at the free float market cap of the BSE Sensex which is more than Rs 39 lakh crore vis-a-vis the largest fund which manages Rs 51,000 crore, as mentioned by you.
Dhirendra: Yes. Indian mutual funds are very tiny right now. If you look at stock ownership on an aggregate basis, mutual funds own just 8 per cent of it. A good part - nearly 51 per cent - is owned by promoters, and then we have FIIs, domestic institutions and insurance companies. So mutual funds are far from there. I don't think they have hit a problem of scale yet.

You've mentioned the positive side. But what's the flip side of a large fund size?
Dhirendra: There are strategies where getting big is a disadvantage. In the context of mutual funds, this is called the winner's curse. I am talking about funds which are supposed to be invested in small or mid caps, or funds whose strategy necessarily requires spotting some opportunity and waiting for it. Winner's curse happens when a fund does very well and as a result a lot of investors put money in it. Suppose a fund could generate superlative returns on a small base of say, Rs 300 crore. Now as investors pour money into it, it becomes a Rs 5,000-crore fund. But what it could do when it was a small-sized fund may no longer be possible because at that size, you can't manoeuvre it. Suppose you earlier had 20-25 stock positions and 10 of them succeeded. Now because the base has grown to Rs 5,000 crore, you will have to look for many other such opportunities. However, the underlying liquidity may not be there.

Many strategies may not be replicable on a larger base. So in case of funds which follow a particular strategy, like investing in small and mid caps, size can be a barrier.

So what's the way out of a winner's curse? Investors would naturally gravitate towards a well-performing fund, wouldn't they?
Dhirendra: Fund managers have to act responsibly. They could stop investors from investing more money. There have been such instances. It is a matter of building a reputation and guarding the interest of core investors. But at the same time it is disadvantageous for the business and so it presents a conflict. When you get more money, you are able to earn more money. The moment you say, you won't take more money, you have to succeed and do well with what you have.

What about debt funds?
Dhirendra: Generally, bigger the better on all counts. You have economies of scale and are able to deploy resources in a better way. You are also able to de-risk yourself. In fact in debt funds, you get one more advantage which you typically don't get in the equity market. The debt market is very informal and is not electronic like the equity market. Here you have someone negotiating the deal while buying the security. And once you have a larger amount of money you are able to get better prices.

But here too, you have the exception. There are certain strategies like the credit opportunities fund which require hard work. But such categories are not meant for a retail investor anyway. The winner's curse applies only to a very small set of funds. But largely, it does not apply.

You mentioned that there is room for negotiation. Can you elaborate on that a bit?
Dhirendra: Think of a fund company which is going to buy Rs 50 crore worth of a security, compared to a person who calls up and says I want Rs 800 crore worth of this security at a yield of x per cent and with a given maturity. The guy will work very hard to serve that Rs 800-crore customer. So the bigger, the better. You are able to negotiate the brokerage or the fulfilment cost.

So what's your final take on fund size?
Dhirendra: I would say that don't worry about it as of now. Worry about it only if you are an investor in small and mid cap funds. The other funds are far from achieving a scale where you have to worry about their size. Just go by their performance track record.

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