Investing in mutual funds? Know the link between size of AUM and returns

Retail investing is rising for both individual stocks and mutual funds.

Prof Parthajit Kayal of Madras School of Economics in this financial express article shares some advice for MF investors. He says investors should invest in small sized funds rather than larger counterparts:

Academic studies have shown that mutual fund schemes with lower funds or assets under management tend to perform better than the popular mutual fund schemes with a large fund under management. In this article, we discuss why it makes sense to go with small-sized funds.

Due to regulatory reasons, most big mutual funds must limit their ownership stakes to 5% or 10% of the total shares of a company. Therefore, it is difficult for large funds to buy enough shares of smaller companies. With this restriction, they end up buying large companies’ shares which are generally traded at a higher valuation.

Generally, investment options get narrowed down as a mutual fund scheme’s fund size increases.

For the large-sized mutual funds, there are only a relatively few investment opportunities that are large enough to make a significant difference to the overall investment returns of the mutual fund portfolio.

Further, mutual funds charge fees or expenses at around 1-2% of the investment value. This means bigger the size of the funds, bigger the size of funds’ profit. Fund managers get a decent share of it as a part of their salary, bonuses, and other incentives. Therefore, it gives more encouragement to raise the fund size instead of trying to generate better returns which play against the financial goal of the retail investors.

Small-sized funds have less competition from the big funds when searching for bargain-priced companies. They have thousands of more companies to choose from when making investment decisions (large-cap, mid-cap, and small-cap stocks). So having relatively small-sized funds is a great advantage in the investment world. Less competition and more choices are a real advantage.

Less-known, small-sized companies are often too small for large funds to invest into or to undertake research coverage. Most of the media houses also do not cover this kind of stock. These lead to less competition from the buyers which means greater opportunity to find bargain priced stocks that could potentially generate high returns in the future. Small-sized fund houses can take advantage of this opportunity by investing in less-followed small capitalisation companies.

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