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Size Matters, Or Does It?

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As the mutual fund industry gathers momentum, it will attract more investors, thanks to the increased awareness as well as the stellar performance of the mutual funds sector. The industry, which jumped from Rs 2,31,900 crore in March 2006 to Rs 6,26,300 crore in December 2010, is expected to be a Rs 11-lakh crore industry by 2015. That is a CAGR (compound annual growth rate) of 15 per cent.

In this scenario, does the size of the fund matter? Is it better for the fund house to float new schemes with the same theme or to enhance the corpus of the existing schemes? To address this, we need to answer the following two questions: i) will the fund invest in large cap stocks or concentrate on mid cap/small cap stocks? and, ii) is it a sectoral or diversified equity fund?
Large caps are those that have a market capitalisation of more than Rs 10,000 crore. As a consequence, a large cap stock has more liquidity (for example, Reliance Industries). The fund manager is able to offload or purchase shares in large quantities without disturbing the market price due to the transaction.

Mid caps/small caps are those with a market capitalisation of less than Rs 10,000 crore. As a consequence, a mid cap/small cap stock has less liquidity (for example, Bajaj Corp.). Mid caps/small caps are also severely hampered due to circuit filters, that deter the fund house from liquidating the stock. 

In fact, one of the major decisions taken by fund managers across the globe is to divide the volume and liquidity of the stocks; if the stocks are not very liquid, most fund managers avoid them.

In the second case, if the fund is a sectoral fund, the very nature of the fund limits the diversification options of the fund manager. Such funds are more focused on a particular sector and the fund has to maintain a significant portion of the corpus as cash, thereby impacting returns. For instance, the Reliance Natural Resources Fund, which was launched in March 2008, took almost 18 months to bring down its cash exposure to less than 10 per cent. However, the fund's returns have been impacted due to the power, and oil and gas sectors becoming stagnant in the past couple of years. On the other hand, a fund manager managing a diversified fund could have shifted his exposure from an underperforming sector, enabling him to capitalise on the market movement. Hence, while investing in a sectoral fund, one would also need to look at the market capitalisation of the sector. Take, for example, the banking index; the total market cap of 14 constituents of the index is Rs 6,30,300 crore. If the market capitalisation of the sector itself is large, the fund will be fine with a rise in the corpus size. 

Another major issue with a ballooning corpus is maintaining a focused portfolio, even if it is with a large-cap mandate. It forces the fund manager to go in for more diversification, thereby increasing the number of stocks being held in the portfolio. For instance, ICICI Discovery Fund had a corpus size of Rs 613 crore in December 2007 with 38 stocks in its portfolio; today, with a corpus of Rs 1,583 crore, the fund has increased the stock count to 68. 

However, the need for increased diversification is not felt by funds with a large-cap bias as has been observed in HDFC Top 200, whose asset size increased from Rs 2,587 crore in December 2007 to Rs 9,489 crore in December 2010. But it has not increased the number of stocks in the portfolio, though it has been able to outperform Nifty and Sensex in all time periods.

It can be concluded that the size of the fund may have an impact on performance; but the impact would depend on its investment mandate and actual investment pattern. If the focus is more towards the mid-cap or small-cap segment, the fund manager will find it difficult to handle the fund if more money flows into it. The same is not true for a large-cap fund, though. 

In the case of sectoral funds, we have to look at the sector and how the investment has been made by the fund manager (component in large-cap). Also, though index funds are not popular in India and have smaller corpuses, these would have no issue in terms of the size of the fund and would mirror the large-cap fund.

The author is the director of Ventura Securities

(This story was published in Businessworld Issue Dated 28-03-2011)