Portfolio Ideas. Keep an eye on fund size

Every mutual fund will give out its fact sheet, with detailed information about the assets under management. In this article, we discuss how you should interpret all this information while selecting a fund.

Is a large AUM better? The answer depends on how the fund’s AUM became large in the first place. A fund’s AUM increases due to two factors.

First, open-ended funds receive continual inflows from investors. This happens especially when a fund performs well. And two, the fund manager generates investment gains. These gains are often reinvested based on the fund’s mandate, which results in higher AUM.

Especially look for increase in AUM because of cash inflows from investors. Large inflows into a fund show investor confidence in the fund manager and the asset management firm. It is the same logic that you use when you choose a restaurant in an unknown city — the more crowded a place, the better it should be!

Likewise, a large AUM, prima facie, appears better. There is, however, one factor you should consider — the fund’s alpha, which is the excess returns that the fund generates over its relevant benchmark index. Now, a fund’s alpha strategy is not always scalable. That is, a fund that generates alpha with AUM of, say, ₹700 crore may find it difficult to sustain its alpha if the AUM increases to, say, ₹3,000 crore within a short period of time. Why? Suffice to know that more money chasing the same universe of investable securities could eventually make it difficult for the fund to sustain alpha. Analysing AUM

So, how should you analyse the AUM? Funds disclose average AUM for each quarter in the fact sheet. Compute the increase in average AUM over 12 quarters. Then measure the growth in net asset value (NAV) for the fund over the same period.

Because NAV is the market value of the portfolio divided by units issued by the fund, any increase in units will reduce the NAV unless the fund generates investment gains.

In a nutshell, if the growth in NAV is more than the growth in average AUM, you know that the fund has also increased its AUM due to investment gains. On the other hand, if the growth in NAV is less than the growth in average AUM, you know that the fund has increased its AUM primarily due to fresh inflows from investors.

And that could be a cause for concern. A fund may find it difficult to sustain alpha if the AUM increases at a fast pace.

This is because the fund manager is forced to find newer securities to invest in or to buy more of existing securities.

Investing in newer securities could also lead the fund manager deviating (marginally or not) from the fund’s objective. A large-cap fund may, for instance, invest in some mid-cap stocks.

On the other hand, investing more money in the same universe of securities could lower the alpha over a period of time, as more money chases the same securities. If the inflows are left idle in cash, it will still adversely affect the fund’s returns.

It is up to you to interpret the information in the fact sheet and use it. The bottom line? It is a cause for concern if the fund’s AUM grows at a rate faster than its NAV. Look beyond 12 quarters to see if the trend persists. If so, sustaining alpha may be an issue for the fund.

The writer is the founder of Navera Consulting. Feedback may be sent to portfolioideas@thehindu.co.in

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