When you want to validate your choice of a consumer durable, checking online stores helps to understand how many individuals have bought the same product. The more the buyers, the better the product ought to be, compared with its peers.

Can you apply the same logic in choosing equity funds? With equity funds, the parallel argument would be to observe assets under management (AUM). Do large AUMs translate to better investment returns?

Also read

It’s time to plan your investments, finances

In this article, we discuss why large AUMs can be good for passive funds but not necessarily so for active funds.

Alpha strategy always scalable?

Take index funds and exchange-traded funds (ETFs). These are passive funds mandated to mirror their benchmark index. Importantly, these funds can only buy stocks that are part of their benchmark.

Your return on an index fund is approximately the benchmark return less the total expense ratio or TER. Now, larger the fund size, typically lower the TER. Therefore, large AUM could be optimal for an index fund as it can generate returns closer to the index because of lower TER.

Large AUMs could be good for ETFs too. Greater the AUM, more the units available for trading in the market. And greater the volumes traded, lower the difference between the buying and the selling prices (bid-ask spread).

Lower spread is an indicator for good liquidity; the more liquid a traded security is, the more likely you will be able to transact at the last traded price (low slippage cost).

What about active funds?

Your primary reason to invest in an active fund is to earn alpha — the excess returns that an active fund can generate over its benchmark index.

Suppose a mid-cap fund attracts fresh capital inflow from investors because of good performance. The portfolio manager may have to invest the capital in a similar set of stocks. But such stocks may have increased in price, thereby, lowering the potential for alpha generation.

Alpha strategy is not always scalable — a strategy that works for an AUM of ₹5,000 crore may not be successful for an AUM of, say, ₹10,000 crore. The NAV growth reflects only the gains generated by a mutual fund.

Therefore, comparing NAV returns to the fund’s benchmark over 3-, 5- and 10-year periods is a good starting point for your analysis of active funds.

(The writer offers training programmes for individuals to manage their personal investments)

Related Topics