The mutual fund industry is among the fastest growing sectors in the country. Investors seeking portfolio diversification, investment expertise and liquidity at a low cost are choosing mutual funds as their investment vehicle.

At the beginning of 2001 mutual funds were managing less than ₹1-lakh crore. This figure had grown to over ₹51-lakh crore by the end of 2023. Though this number is still lower than bank deposits, it is growing at a higher rate.

The most important and fastest-growing part of the mutual fund industry is funds that invest in stocks. The proportionate share of equity-oriented schemes in the total assets is more than 56 per cent of the total assets and more than 89 per cent of these assets are owned by individual investors (retail + HNI).

Per SEBI’s classification, there are many categories of equity-oriented schemes — large-cap, mid-cap, small-cap, multi-cap, and so on. Of late small-cap funds have caught the fancy of the investors.

Small-cap scale-up

At the end of 2019, 21 small-cap funds had around ₹48,534 crore of assets under management (AUM). By the end of 2023, 27 small-cap funds had AUM of ₹2,33,979 crore, resulting in the mean size of the funds increasing from ₹2,311 crore to ₹8,665 crore.

Market capitalisation of small-cap companies (companies below 250 in ranking) has gone up from 11.26 per cent in December 2019 to 17.83 per cent in December 2023 of the total stock market capitalisation. And the AUM of small cap funds as percentage of small cap market capitalisation has gone up from 2.92 per cent to 3.97 per cent during the same period.

An understanding of the effects and implication of fund size is an important and critical issue as it has scale implications which affects the agency relationship between the mutual funds and their investors.

Practitioners point out various advantages of managing a fund with large size. Many expenses of fund management do not vary in proportion of the assets under management and, therefore, an increase in size may lead to spreading over of expenses over a large asset base, reducing the expense ratios. The flip side is that a large asset base may increase the costs and risks due to liquidity or price impact.

How liquidity influences the fund management is that a small size fund can easily put all of its money in its best ideas, whereas lack of liquidity may force a fund of large AUM to invest in its not-so-good ideas and/or take larger positions per stock than what is optimal, thereby affect the performance.

The fund manager of a ₹20,000-crore fund does not select stocks the same way he or she would, if managing only ₹5,000 crore. The weighting decisions across investment opportunities is not independent of the size, as it may not even be feasible to invest ₹20,000 crore at the same portfolio weights as ₹5,000 crore. The increased cost of liquidity makes this option undesirable. While almost all securities have prices that are sensitive to large orders, small-cap stocks are more price-sensitive than large-cap stocks.

Of course, a large fund can afford to hire analysts/managers to cover more stocks, and can thereby generate additional good ideas so that it can take small positions in lots of stocks as opposed to large positions in a few stocks. Indeed, the vast majority of stocks with small market capitalisation are untouched by mutual funds. So theoretically there is scope for even very large funds to generate new ideas.

However, majority of these stocks have poor liquidity. So whether the number of stocks are increased or the positions in the same set of stocks, liquidity does remain a matter of concern when the size of the fund increases.

Count goes up

The total stock count for all the 21 small-cap funds that can be compared between the two periods 2019 and 2023 has gone up, in some case by as high as 90 and in other case as low as two stocks.

Of the top five small-cap funds, three of them have their number of stock holdings increased by less than 10 stocks. Percentage holding in top 10 and top five stocks have gone down in many funds though not in all.

A key challenge in this space is that it is difficult to measure liquidity transformation risks for small-cap mutual funds. One key driver of higher return for small-cap stocks is illiquidity. The expectations of higher returns have led to large inflows into small-cap funds. Liquidity transformation is a key structural element of mutual funds. Liquidity concerns are an area of consideration for regulators and the industry alike.

Since unit-holders own claims whose value is not fixed but derived from the assets the fund owns, some price impact can be passed on to the unit-holders. Still, fund managers are expected to perform some amount of liquidity transformation as liquidity is a key attribute why people choose to invest in mutual funds.

One possible response to liquidity constraints is to close the fund to new investors. However, since mutual funds companies get compensated on assets under management, very few have voluntarily restricted fresh inflows into their funds. Others perhaps require regulatory nudging.

The writer is Professor & Dean (Academics), School for Securities Education, National Institute of Securities Markets (an Educational Initiative of SEBI)