Whalesbook
How Fund Size Hurts Returns
As Indian mutual funds grow larger, their performance can be negatively impacted. While strong inflows and market gains have pushed Assets Under Management (AUM) to record levels, the sheer size of some funds raises questions about whether they can keep up their past performance.
This means investors need to look past headline returns and understand how fund size affects investment decisions and strategy.
The AUM Drag: Size vs. Alpha
Decades of academic research and recent Indian market data consistently show a link between increasing fund size and declining returns. Funds managing tens of thousands of crores face significant liquidity challenges. Large trades can move market prices, making buying and selling costly. This can force funds to invest in less attractive options just to use up their cash. This effect is most noticeable in mid- and small-cap segments, where stock liquidity is naturally lower. Funds like SBI Large Cap (₹55,246 crore AUM) and ICICI Prudential Large Cap (₹77,452 crore AUM) have shown returns below average over three and five years. This suggests they are increasingly acting like expensive index trackers. With broad diversification and a focus on large stocks, they struggle to generate significant extra returns (alpha) at this scale.
Funds Overcoming Size Challenges
Despite these difficulties, some funds show remarkable resilience, proving size is a challenge but not an impossible barrier. The Parag Parikh Flexi Cap Fund, one of India's largest with an AUM over ₹1.34 lakh crore, maintains a strong performance record. This is due to its strategy of investing in larger, more liquid domestic and international stocks, a focused portfolio (typically 30-35 stocks), and a patient, low-turnover approach. By including international stocks, the fund broadens its investment options and eases domestic liquidity issues. Similarly, the Nippon India Small Cap Fund, despite its substantial ₹67,642 crore AUM, has delivered strong five-year returns of about 21.89%, beating its benchmark. However, managing this much money in the less liquid small-cap space means holding many stocks. This raises concerns about having to diversify too broadly and eventually matching index performance. The HDFC Mid Cap Fund, managing ₹94,257 crore, also shows strong returns thanks to its heavy focus on mid- and small-cap stocks, though whether it can sustain this performance at such a large size is uncertain.
Key Risks: Liquidity, Slow Decisions, and Hidden Costs
The biggest negative impact of large AUM is seen in the small-cap segment. Funds with huge assets can't invest large amounts without moving stock prices. This often forces them to buy bigger, mid-cap stocks, weakening their strategy and potentially lowering returns. This liquidity issue was clearly shown during stress tests required by SEBI in 2025.
Beyond liquidity, slower decision-making processes within large organizations can dilute investment ideas and conviction. Funds managed by a single person have historically performed better than those co-managed, and this effect is stronger with size. There's a risk of 'closet indexing' – investors paying active management fees for returns similar to an index fund. This happens when funds can't find enough unique, high-conviction ideas once their AUM exceeds a certain level, often around ₹40,000 crore.
Regulatory moves, like SEBI's proposal to set a ₹20,000 crore threshold for classifying indices as 'significant,' show increasing attention on how large fund sizes affect market benchmarks.
What Investors and Funds Must Do Next
The Indian mutual fund industry continues to grow strongly. Total AUM reached about ₹81.54 lakh crore by March 2026, fueled by steady regular investments (SIPs).
For investors, the key question is no longer just past performance but whether a fund's current size allows it to access the same opportunities that drove its past success. A fund that achieved great returns with ₹5,000 crore faces a much tougher execution challenge at ₹50,000 crore.
Investors need to consider fund categories. Large AUM can be good for large-cap and debt funds but a major hurdle for mid- and small-cap strategies.
Fund houses (AMCs) might launch more focused funds with strict AUM limits or create new active management strategies to counter the size penalty. Investors, meanwhile, must prioritize flexibility and closely monitor AUM when choosing funds.