The Hindu Business Line : Why size is no problem for equity funds

Fund size is a relative metric. Size is not yet an issue for a diversified fund that can choose any stock in the Indian investment universe. The pattern of inflows into a fund and the churn in its assets play a far greater role in performance.

FOR a mutual fund, popularity sometimes extracts a price. This week, Reliance Growth Fund, a top-ranking equity fund, temporarily shut its doors to new investors after receiving more inflows than it felt it could profitably deploy.

The fund said it was suspending sale of new units because increasing the fund's size further may prove detrimental to its investors.

There are seven other equity funds that are as big as, or even bigger than, the Reliance Growth Fund. Investors may wonder if some equity funds are becoming too big to deliver index-beating performance.

They need not worry. Fund size is a relative metric. Size is not yet an issue for a diversified fund that can choose any stock in the Indian investment universe.

Though it is a constraint when a fund restricts itself to a limited set of stocks. Even then, the pattern of inflows and the churn in assets play a far greater role in its performance than its absolute size.

A fraction of the market size

It is early days yet to worry about fund size, because Indian equity funds are so small in the overall scheme of things, says Mr K. N. Siva Subramanian, Senior Portfolio Manager for Franklin Templeton Mutual Fund.

"Our stock market capitalisation is now at $400 billion; there is not even a single fund that is even a billion dollars in size", he pointed out in an interview last week.

Most fund managers agree; they feel that even a Rs 1,000-1,500 crore equity fund could significantly ramp up its size without a blip in performance, provided it holds a diversified portfolio.

Several offshore funds investing in India manage three or four times the assets of the big home-grown funds, and yet manage to do as well. Size could be a problem for a fund that restricts itself to a limited universe of stocks, whether in a sector or a small segment of the market.

Managers feel that a fund that sticks to technology or consumer goods stocks, should probably manage no more than Rs 300-400 crore. Likewise, a size of less than Rs 500 crore may be ideal for a fund that promises to sniff out small-cap companies.

Size can be managed

But even these numbers are not carved in stone. As the universe of investible stocks expands and their trading volumes surge, funds that chase small or mid-sized companies too could begin to handle more assets.

Franklin Templeton's 10-year old mid-cap fund — Prima — is now at Rs 1,600 crore.

With its one-year return at 80 per cent, size has obviously not turned this fund into a laggard. Mr Siva Subramanian says that he has found that there are always stocks to be bought and sold on a bottom-up basis, irrespective of market conditions.

The Prima Fund has managed its expanding size simply by spreading its exposures over a larger number of stocks. A new portfolio manager has been brought in so that the investment coverage expands.

Flows more important

The pattern of flows into a fund is far more important than its size and also far more difficult to manage. Inflows into open-end equity funds typically chase good performance and tend to accelerate when valuations climb. Money also tends to chase the best performing segment of the market. If technology stocks posted phenomenal gains over the past few months, investors piled into technology sector funds.

If mid-cap stocks lead the rally, mid-cap funds receive a deluge of subscriptions.

In this case, Reliance Growth Fund's dilemma seems to stem not so much from the fund becoming too large to manage, but from the inflows it has received in the past three months.

The fund invests predominantly in mid-cap stocks and many managers now perceive mid-cap stocks as expensive.

When a mid-cap fund receives big inflows at this juncture, the fund manager could find it difficult to deploy the money in the short term. This may entail holding a cash position, which could drag performance.

The fund probably wants to avoid this by shutting its doors to fresh subscriptions for a few months. Obviously, badly timed inflows can create problems for any fund, irrespective of its size.

Watch for churn

High churn in a fund's assets can inflict even more damage. Inflows force a fund manager to scout for deployment opportunities when market conditions may not be ideal for investment; handling churn could be even trickier.

When a fund alternates between big inflows in a month and an exodus in another, a fund manager is forced to replace a significant portion of his portfolio at short notice. This may force him to make poorly timed "buy" and "sell" decisions.

These could be quite damaging to the fund's performance. If churn results in a large portion of the portfolio being replaced at high market levels, long-term performance too could suffer.

More than size, investors in equity funds, therefore, need to watch the pattern of inflows and outflows from an equity fund, when they make an investment decision. This can easily be gauged from the changes in a fund's assets from month to month, available on the AMFI (Association of Mutual Funds of India) Web site.

As to churn, the mix of investors in a fund can be an important pointer to the possibility.

Information on the large investors in each fund is available from the half-yearly disclosures of mutual funds. More disclosures would be welcome and would provide significant inputs to the investment decision.

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