If a fund performs exceptionally well with highest returns in a category, more and more money from investors flows into the fund, and then a time comes when the fund manager is not able to generate the same return as he/she was generating when the fund size was small. The fund eventually drops down from top position in the category to a lower position, based on the returns. This is called winner’s curse in mutual fund. For example – This happened with Axis small cap fund few years back, and happening with most of the Quant mutual fund schemes now.
As discussed in our previous blog, small fund size or AUM is easier to be managed. Please refer to the link below for previous blog:
The difficulty of managing higher AUM is most difficult in case of smallcap funds wherein the size of companies are small (with market cap of few thousand crores) as compared to large or mid cap funds.
Winner’s curse is something that cannot be avoided. Then, how does investor decide on sticking to a particular fund?
First of all, when an investor starts, it’s always good to start with a consistent performing fund. It is good to watch few interviews of the fund manager to understand his/her style of investing. It is recommended to be invested in a fund being managed by a fund manager having good track record of performance.
Now, suppose an Investor A has done all these and chosen a fund which is in top 25% funds of the category based on returns. The fund performs better and secures rank 1 in the category based on returns. This will draw attention of more and more investors to the fund, and the inflow to the fund will increase. It will probably increase to a limit wherein money in the fund becomes difficult to manage, and eventually fund drops from rank 1 to a lower rank based on returns. So, should investor A exit at this point?
To answer this question, there are few things investor should be checking:
- Is the fund manager same with whom investor A started?
- Is the fund consistently performing in 3, 5 and 7 years period, beating the benchmark and category average return?
If the answer to the two questions above are ‘Yes’, it is a good idea to continue with the fund. Because what would probably further happen is that when the fund drops from rank 1 to a lower rank based on returns, the high inflow would stop, and in some cases there could be outflow as well. Even if there is no outflow, but as the market size increases, it becomes again easier for the fund manager to manage the fund and generate superior returns.