Size matters, they say. And, the Indian mutual fund (MF) industry certainly believes in this mantra. Little wonder then that the top MFs advertise their assets under management (AUM) and new fund offers (NFOs) highlight how large an amount they have been able to collect. A higher corpus also gives MFs room to bargain for lower fees to their distributors.
But does a fat MF scheme really benefit you - the investor? How important is the size of an MF scheme? Can a bloated corpus impact the scheme's performance?
Falling from grace
Three prominent MF schemes - Franklin India Prima (FIPF), Sundaram BNP Paribas Select Mid-Cap Fund (SSM) and SBI Magnum Global '94 (SMGF) - were once five-star rated funds in the Outlook Money annual MFs rankings. They are now languishing in the middle to the bottom quartiles. What is common between the three, besides large corpuses, is that they are all mid-cap oriented funds.
Take the case of FIPF. After remaining in the top quartile from 2001 to 2005 (it topped the charts in 2001 and 2003), it started dwindling from late 2005. Its corpus crossed Rs 1,600 crore in 2005, up from Rs 260 crore in June 2003. In 2006, FIPF underperformed the category average return of 32.3 per cent and returned 24.1 per cent. The year 2007 has been no better. It returned 31.3 per cent as on 31 August on a one-year basis against a 37.5 per cent category average.
SMGF and SSM had similar fates. After dominating the category from 2004 to 2006, the performances of both these schemes started to drop. As on 31 August, SMGF and SSM retuned 39.7 and 29 per cent on a one-year basis, respectively, as against 37.5 per cent returned by the category average. In this respect, they finished ninth and 20th, respectively, out of a total of 22 mid-cap funds in the market.
Note that the performances of these funds started to drop noticeably only after their corpuses started to swell. The problem is not as rampant in large-cap oriented funds.
To keep matters simple, let's define a large-sized fund as one whose assets are more than Rs 1,000 crore. Out of 186 diversified equity funds, 46 have crossed the Rs 1,000-crore mark. Of these, eight are mid-cap funds with only four having a track record of more than three years. One needs to track a fund for at least three years to check whether a rising corpus has impacted its performance.
Size matters
Since all these funds have a good long-term track record (FIPF is over 10 years old), they have attracted consistent inflows over a period of time.
Once MFs get inflows into existing schemes, they have two choices:
Deploy in the markets. This is the easiest and an ideal option. Either MFs increase exposure to existing securities, or buy into new stock ideas they expect will deliver returns in the long run.
But this can have its own side effects. Typically, mid-cap funds are well-diversified and boast of at least 40 to 60 scrips in their portfolios. When mid-cap funds buy new stock ideas, the number of stocks in their portfolios goes up. That means more stocks to track on a daily basis.
The problem gets further compounded because the illiquidity in the mid-cap segment that worsens during volatile phases. Sample this. When the stockmarket crashed in May 2005, the average of the monthly traded (average) quantity of all stocks within the CNX Midcap Index was around 158,898 shares against 3,79,479 shares of Nifty scrips (large-cap scrips). The lowest traded scrip in CNX Midcap Index during this month was Monsanto India that traded just 637 shares on an average.
Compare this to the least traded stock in Nifty in May 2005 - ABB traded 3,583 on an average. The story has been similar during other volatile bouts in the past two years.
During volatile phases, investors prefer to stick to well-established and well- researched large-caps instead of mid-cap stocks. This is because many of these mid-caps are under researched and are small-sized companies.
On account of the illiquidity in the mid-cap segment, mid-cap fund managers do not typically take large exposures in them. Instead, they prefer to hold small exposures over a large number of such companies.
For instance, SSM held 113 scrips at the end of 2006 - with the topmost scrip accounting for merely 3.8 per cent of its total corpus - as against 69 scrips in January 2005. This was on account of the increase in the fund's size to Rs 1,815.5 crore, up from Rs 406.9 crore, a jump of 476 per cent, in this period. Small exposures over a large number of scrips drag the fund's performance down as a spike in few scrips fails to lift the entire portfolio.
Hold cash. When MFs don't find convincing stock ideas, they hold cash. This is a double-edged sword. If the market falls, schemes with a high cash allocation typically fall the least. However, if the market rises suddenly, funds with higher cash allocation lag behind. For over a year, between May 2006 and April 2007, SSM held close to 30 per cent in cash. SMGF, too, suffered on account of sudden inflows in the first half of 2007. Due to this, it's cash allocation went up to 19 per cent on an average, up from last year's average of 7 per cent.
Taking action
So, what have mid-cap funds been doing to tackle the continuous inflows?
Some mid-cap funds have the flexibility to invest a certain percentage of their corpuses in large-cap scrips. For instance, Reliance Growth Fund (RGF) has consistently invested up to 25 per cent of its corpus in large-cap scrips, up from around 15 per cent in 2005. Says RGF fund manager Sunil Singhania: "Holding a small portion in large-caps gives us comfort in challenging times and we are not forced to sell our best mid-cap scrips at throwaway prices."
Clearly, the strategy, apart from a nimble fund management, has paid off for RGF. Despite being the largest mid-cap fund (Rs 4,082 crore as per July 2007), RGF still remains one of the best mid-cap funds around. It returned 44.4 per cent as on 31 August against 37.5 per cent by the category average. "We pick up companies available at good prices, rather than good companies at any price," adds Singhania.
Other large-sized mid-cap funds have also adopted a similar strategy and either invested a portion in large-caps or the upper echelons of mid-cap scrips. FIPF's average market capitalisation (of all its underlying scrips) has gone up to Rs 2,949.1 crore in 2007, up from Rs 1912.3 crore in 2005. On the other hand, SMGF's market capitalisation was around Rs 3000.8 crore in 2007, up from Rs 1543.5 crore in 2005.
SBI MF's chief investment officer Sanjay Sinha told us that if SMGF's corpus keeps growing, they will increase the upper market cap limit of the scrips that SMGF can invest in to Rs 10,000 crore, up from Rs 5,000 crore currently.
However, not all funds are open to holding large-cap scrips. Says Sandip Sabharwal, one of the best mid-cap fund managers in the Indian MF industry and JM Financial MF's fund manager: "If a fund house is selling a mid-cap fund, then by holding large-cap scrips in it - even if they are in minority - disturbs the fund mandate."
Reducing cash levels
Mid-cap funds have increasingly begun to realise the perils of holding high levels of cash in their portfolios. SSM has deployed most of the 30 per cent cash in the past two months. Besides, it has also brought down the number of scrips to 70 (as per its August-end portfolio) from around 110 earlier. Trimming a portfolio increases the potential to earn higher returns if the fund is managed well.
Ramping up fund management
Some MFs are in the middle of ramping up their fund management team. For instance, SSM and Franklin Prima were badly hit on account of the churn in their fund management team. While four fund managers/analysts quit Franklin Templeton in the past three years, SSM's fund manager, Anoop Bhaskar, moved to UTI MF in February 2007.
SBI MF now has two fund managers for all its schemes, including SMGF. It has also increased the number of analysts who track mid-cap stocks. While Franklin Templeton claims to have revisited their approach and strategy for managing FIPF, SSM, too, has got a new fund manager.
Closing doors
The most investor-friendly way to fight the bulge is to close its doors to inflows. Although the fund remains in existence and its customers continue to remain invested in the fund, further sale of units is stopped. A common practice in developed markets like the US, this has yet to find favour with Indian MFs. Franklin Templeton and Reliance MFs tried walking this road, albeit for a brief while. While FIPF closed for further subscriptions for six months in 2006, RGF closed for three months in 2005. But, both these funds opened their doors once again.
What should you do?
Although the restructuring can improve the performance, there's no telling when the turnaround will happen. It's hard to give up a once-strong fund, but if you own mid-cap funds where size is dragging the performance, it's best to sell and move on to something more promising.
