How does a huge AUM affect the performance of a small-cap fund?

How does a huge AUM affect the performance of a small-cap fund? Till what level is it safe to invest?
-Rajat

Small-cap funds face a problem when they get bigger because there's a dearth of ideas. There is a difference between managing a small-cap fund and a large cap or a well-diversified equity fund, simply because small caps are very idea intensive. When you look at a large-cap fund run by one fund manager compared to different fund managers or an index fund, the overlap of the portfolios can well be around 80 per cent because large-cap funds are supposed to invest in just the top 100 companies. So if you have to choose 25 of these 100 companies to build a portfolio, 20 of them might be the same. The other advantage of large-cap funds is that one doesn't need to worry about their liquidity. They are available in plenty and don't have a huge impact cost even when investors carry out transactions worth Rs 100-200 crore in a day. However, this may not be the case with a small-cap fund. Many small-cap companies are usually worth about some Rs 1,000-1,500 crore. To buy a meaningful position in such a company, it is still okay for a fund managing around Rs 100-200 crore of assets. But for a much bigger fund, taking a 5 per cent position in many small-cap companies will not be possible, and it may also not be easy to sell these positions when they want to.

So, building meaningful positions in a small-cap fund could get hard with an increase in assets under management (AUM). Once a fund gets bigger, it has to look for more ideas. Even the liquidity challenge can be dealt with only by having more companies in the portfolio. But finding these companies is not easy, and discovering a relatively not-so-richly valued and unspotted small-cap company takes effort.

Coming to its impact on the performance, there is something called the 'winner's curse' in the mutual fund space. When a small-cap fund does well, investors pour money in. Then the bigger asset size acts as a barrier to performance because of the reasons I have just mentioned. So if a small-cap fund wins, it is cursed, and if it doesn't win, it's not being liked anyway.