Of Bollywood, Mutual Funds, and INR 100 Bn AUM

Some of my friends are Bollywood aficionados. They are informed of not only which movies are being screened, but also their box office numbers. As a result, even I have become familiarised with terms such as “the 100 crore club”. For the uninitiated, apparently box office collections of at least INR 100 crores (INR 1 billion) is a parameter for a movie to be considered a success.

Oddly, a somewhat similar scenario is brewing in mutual funds. Thanks to a combination of steady inflows and rising markets, several equity-oriented funds have an asset size exceeding the INR 10,000 crores (INR 100 billion) mark.

However unlike box office numbers, growing assets of mutual funds are giving some investors and distributors sleepless nights.

Is the evaluation parameter apt?

An evaluation parameter must be based on sound logic for it to be relevant.

Let’s consider the 100 crores mark for movies. Say movie “ABC” costs INR 30 crores to make, and its box office collection is INR 70 crores. Compare this with movie “XYZ”, which costs INR 90 crores to make, and clocks proceeds of INR 110 crores.

Now if grossing INR 100 crores is the benchmark of success, then “XYZ” has succeeded, while “ABC” is a failure. However, if cost is considered, it is apparent that “ABC” is more profitable (hence, more successful) versus “XYZ”.

Clearly, selecting an apt benchmark is vital. This principle holds good in the case of mutual funds too.

Does size matter?

Asset size can matter because a mutual fund operates within the restraints of liquidity, market cap, and availability (listed stocks). That said, jumping to a conclusion such as “large asset size=bad, and small asset size=good” would be naive.

Let’s consider small and mid-cap funds. Here, a large asset size can pose challenges in the form of market-impact cost, the opportunity cost of having to spread trades out over longer periods, and liquidity management.

Conversely, a large asset size offers economies of scale. In India, regulations ensure that the expenses charged to a fund reduce, as size grows. In categories such as liquid funds wherein margins are wafer thin, a competitive cost structure aids the investor’s cause in no small measure.

Furthermore, in certain segments of debt markets (such as government securities), the minimum lot size is substantial. As a result, a small-sized fund may not be able to invest in it, thereby depriving investors of a wholesome investment experience.

Simply put, no blanket rule can be applied. The relevance of a mutual fund’s asset size depends on the individual specifics of each case.

Is INR 100 billion a sacrosanct number?

It’s hard to figure out why there is so much focus on the asset size of INR 10,000 crores for equity funds. To begin with, that number isn’t backed by any reasoning. Furthermore, as we learned from the case of the “100 crore club”, a number in isolation means little.

Let’s take the case of a large-cap equity fund with assets of INR 17,000 crores (INR 170 billion). In absolute terms, one might be inclined to believe that the fund’s size is substantial.

However, the size amounts to roughly 0.36% of the S&P BSE 200’s (an apt benchmark index) free-float market cap. In other words, the fund isn't really large.

Conversely, a small-cap fund with a size of INR 5,000 crores (substantially lower than the "hallowed" INR 10,000 crores) could struggle to freely invest without hampering performance.

What investors must do

Instead of focusing on the asset size in isolation, investors would do well focus on the consequences of a growing size.

To begin with, not every portfolio manager is skilled enough to manage a large-sized fund; neither is every investment style adaptable to a large fund.

Look for signs of stress—the manager’s investment style changes sharply, the portfolio acquires a tail which doesn’t add value, the long-term showing consistently falters.

A growing asset size could result in the fund’s character undergoing a fundamental change. For instance, a fund that made its mark as a small/mid-cap fund could end up becoming a large-cap fund.

In such a scenario, investors must evaluate if the fund yet merits a place in their portfolios. If the intention was to invest in the small/mid-cap segment, then corrective steps are in order.

Finally, in cases wherein despite a growth in asset size, there is no discernible change either in the portfolio manager’s investment style and the fund’s character, investors should ignore all the noise and stay invested.

Why Investors Shouldn’t Deify the Portfolio Manager

In the recent past, debt mutual funds have witnessed two significant events. Oddly, these seemingly unrelated events have evoked an identical response from investors.

In the first week of February 2017, RBI’s Monetary Policy Committee unanimously voted in favour of keeping policy rates unchanged. It was widely anticipated that the central bank would cut rates in keeping with the accommodative stance it has adopted over the last two-odd years.

Debt markets reacted negatively to the pause in rate cuts, with bond yields surging sharply.

Several portfolio managers running debt mutual funds had increased the maturity of their portfolios, to capitalise on the anticipated rate cut. Expectedly, their performance took a significant hit.

Last week, some debt funds from Taurus Mutual Fund were in the news on account of their poor showing; the funds posted losses ranging from 7% to 12% in a single day. The reason—they were invested in debt instruments from Ballarpur Industries. A credit rating agency downgraded the issuer’s long-term rating, on account of “delays in debt servicing by the company”, among others. The episode brought back memories of similar instances that have occurred in recent times.

In both the aforementioned instances—RBI keeping rates unchanged, and Taurus Mutual Fund’s credit bets—it is evident that portfolio managers were pursuing distinct investment strategies. In the former, managers were engaging in duration plays, while in the latter, taking credit risk was central to the strategy. However, both strategies came a cropper to the chagrin of investors.

Deifying the Portfolio Manager

Since then, I have had conversations with several investors. The most common refrain was that portfolio managers are to blame. But the grouse wasn’t along the lines of the justifiable “portfolio managers need to take responsibility for poor investment decisions”.

Rather it was akin to “how could the portfolio manager make a mistake?”

On digging deeper, I learnt that their rationale was: The portfolio manager is an investment expert. He gets paid a sizeable compensation for running the fund. Hence he shouldn’t be making a mistake, and as a result, exposing investors to a loss.

I was surprised to note that many investors view the portfolio manager like a superhero who cannot err. And therein lies a fundamentally flawed line of thought.

Selecting the Portfolio Manager

Admittedly, the portfolio manager plays a significant part in determining the fund’s fortune. Also, it must be stated that portfolio managers encompassing the entire spectrum—mediocre to supremely talented—exist in the mutual fund industry. Hence, the importance of selecting the right portfolio manager cannot be overstated.

One would expect the manager to be skilled, and have proven his mettle over the long haul. He must have successfully plied his craft across a market cycle. Furthermore, he needs to demonstrate confidence in his abilities by investing substantial monies in his funds alongside investors.

Simply put, the portfolio manager must indisputably earn his stripes before investors can entrust him with their monies.

Pragmatic Expectations and Evaluation

On their part, investors must be pragmatic while evaluating the portfolio manager. Investors would be justified in expecting the manager to get more calls right than wrong. For instance, a manager running an active strategy is expected to beat the benchmark index over the long haul.

However, expecting him to never err, or deliver a positive return consistently is unrealistic. Even the best of managers, can and will make a poor investment decision at some point. That is par for the course in market-linked investing.

Idolising the manager can also hurt investors by preventing them from making an accurate evaluation when the manager hits a purple patch. Consider the case of a manager who takes on unduly high risk to clock superior returns.

The Flipside of Deification

There’s a marked difference between holding the manager to high standards, and having unrealistic expectations. The latter can lead to disenchantment, and investors turning their back on mutual funds.

Sadly, investors whom I interacted with seemed to be leaning in that direction. They have jumped to the conclusion that since the portfolio manager cannot guarantee success, they are better off investing on their own. For most, that isn't the right course of action.

What Investors Must Do

Investors would do well to understand how portfolio managers operate, and then devise an evaluation system that works for them. A manager who fails to retain the investor's confidence should be penalized.

But deifying the portfolio manager and expecting him to deliver in a like manner is neither rational, nor in the investor's interest.