The incredible advantages of managing smaller AUM

A well-informed investor managing smaller AUM (Assets under management) has a significant advantage over large fund managers. This advantage applies across all market capitalizations, regardless of the size of the companies being invested in.

With advancements in technology and SEBI's initiatives, data is now accessible to everyone simultaneously, levelling the playing field for all investors.

Some of the key advantages of Fund Managers managing smaller AUM are:

Focused Portfolio Advantage

A fund manager managing smaller AUM can build a concentrated portfolio of around 20 stocks, achieving reasonable diversification while ensuring meaningful allocation to each holding.

Let’s consider data from the Top 10 largest small-cap mutual funds by AUM. The 10th largest fund has an AUM of ₹12,544 crore. The number of stocks held in these funds ranges from a minimum of 58 to a maximum of 227.

Source: Rupeevest, 21st Jan 2025

Having such a large number of stocks often creates a "long tail" of holdings with insignificant allocations. This can lead to underperformance. Why?

When a portfolio includes stocks with minimal allocations (e.g., 0.5%), it becomes easier to overlook poor performance, hoping these stocks might improve in the future. This leniency often results in holding onto underperformers for too long. Over time, these small, poorly performing allocations can accumulate and drag down the overall portfolio performance.

In contrast, a fund manager with a smaller AUM who holds a concentrated portfolio of just 20 stocks can assign a meaningful allocation to each holding. This enables them to act decisively, cutting losses on underperforming stocks and reallocating capital to stronger performers. This disciplined approach often translates into superior performance for smaller fund managers and individual investors.

Liquidity Challenges

Despite having over 2,000 stocks listed on Indian markets, daily trading volumes are relatively low, with only about 200 stocks averaging daily volumes of ₹100 crore

Source: NSE bhavcopy, 17th Jan, 2025

Why does this matter?

For a fund manager managing say 15,000cr AUM to build a 4% position of 600cr in one of the top 200 stocks is going to take more than a week. The above table shows only the traded value the actual delivery volume will be a small percentage (25-40%) of it.

He needs to be extremely sure before buying anything because once he buys there is no exit. And the cost of entry and exit are quite high. That is the reason we see long tail of stocks in most small cap funds.

Returns are driven by the process

Having a smaller Assets Under Management (AUM) is not a guarantee of outperformance; rather, it serves as a facilitating factor. The returns generated depend on the investment processes employed by each fund manager.

A smaller AUM allows fund managers the flexibility to implement strategies that are closely aligned with the earnings performance of the companies they invest in coupled with technical factors. They can purchase stocks once a company's earnings begin to materialize and quickly sell off underperforming stocks to reinvest in those with stronger earnings potential.

Implementing this strategy at the portfolio level enables consistent capital compounding over the long term. Instead of specifically targeting multibagger stocks or exceptionally high returns, the focus remains firmly on the earnings potential of the companies.

For simplicity's sake, I am assuming that fundamentals and valuations are foundational considerations for every fund manager.

Opportunistic Investing

Smaller funds can pivot to capitalize on short-term opportunities that may not be practical for larger funds.

Intellectual Challenges

In the markets, certainty is never absolute; investments are based on research and probabilities. Mistakes are inevitable, and even a 50% success rate is considered exceptional. A smaller investor with minimal media scrutiny can often exit a position quickly if they’re wrong, sometimes within a day. However, for large institutional setups, this flexibility is limited due to concerns like credibility, job security, and reputational risks.

Better Risk Management

A smaller fund size allows for more focused and hands-on monitoring of individual positions, potentially leading to better overall risk management.

Summary

During his 1999 Berkshire Hathaway Annul meeting Warren Buffet said

“If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money”

With all due respect, the fund managers overseeing small-cap funds are truly exceptional. However, the size of the assets under management (AUM) significantly impacts their performance. While managing a lower AUM comes with challenges like limited scalability and revenue potential, it offers distinct advantages such as enhanced flexibility, agility, and the ability to generate alpha. These attributes can serve as a competitive edge, particularly for boutique investment firms or managers with a niche focus in the equity markets.