Jul-Sep 2013

A Perspective on the Mutual Funds Industry in India

Aditya Agarwal, the Country Manager of Morningstar India, has 20 years of experience in the financial services and investment management industry. He was the promoter of one of India’s leading fund research companies, ICRA Online, and is highly regarded as a subject matter expert on mutual funds. In a conversation with Professor Vikram Kuriyan and Nupur Pavan Bang of the ISB’s Centre for Investment, Agarwal discussed the reasons for the slow growth of the Indian mutual funds industry compared to developed markets and explained why investor education and awareness is required.

India accounts for 18% of the worlds population but only 0.37% of the global mutual funds industry in terms of assets under management, as per data from the Investment Company Institute. India has one of the highest savings rates in the world at about 33% for the year 2012. But this money does not find its way into the stock markets or mutual funds. Why is this so?

It is true  that only a meagre fraction  of the savings in India  goes into stocks or mutual funds. Indians prefer  real assets such as gold and property to stocks or equity  mutual  funds. Many risk-averse investors prefer  to keep  their money   safe  with bank fixed deposits, and some even prefer to hold cash.

The primary reason for this  is a general lack of awareness among individual investors about how stock markets work.  Thirty  years ago, the BSE (Bombay Stock  Exchange)  Sensex was  at  125, whereas  10 years ago, it was near 4,000  levels. Thus, if you held a portfolio  of the top blue-chip  stocks similar to the BSE Sensex and left it untouched, your wealth would have grown 150 times and 4.5 times in 30 and 10 years respectively,  or at a compounded annual growth rate (CAGR) of about 18% in both cases.

However, in most cases, investors fail to recognise that stocks and mutual funds are best when held over a longer term,  say five years or more, for the volatility to even out, and instead, trade in stocks for the short term, leading  to disappointing   results.  Financial literacy needs to improve in the country. Despite all the efforts  from  the regulator and various investor education initiatives run by fund companies, financial planners, and so on, the buy-in  from  investors just isn’t  there. Funds are still  not bought;  they have to be sold to investors.

It is no secret that stocks generally outperform all other  asset classes over  the  long  term  – this  has been  demonstrated   and  proven  in ever y  market over different  time  frames; however, a relative lack of understanding of this  among  investors,  and  as a result, their bitter experience with the asset class, has resulted in Indian  savings not  being channelled  into the asset class as much  as they should be.

In most cases, investors fail to recognise that stocks and mutual funds are best when held over a longer term, say five years or more, for the volatility to even out, and instead, trade in stocks for the short term, leading to disappointing results. Financial literacy needs to improve in the country.

Private players entered the mutual fund industry in 1993. The industry is 20 years old today, but yet it is far from mature. What are the reasons for this? In terms of accountability, mutual funds have not performed well or beaten the benchmark consistently.

The entry of private  players has definitely raised the standard  and  professionalism  of the  industry,  but that is unlikely  to have a bearing  on  the  industry’s growth.  The reason for this is that with 75% of the industry’s  assets in debt and liquid  funds, it serves institutions well to park their surplus funds and gain a tax advantage. Until the average retail investor starts to believe in a big way that  wealth  can be created from  equity investments, we won’t  see the industry maturing in the way it has in developed markets.

On the question of funds not performing well, we often confuse poor returns stemming from  the market’s dismal performance during the past five years (five years ago, stocks were nearing the end of a multi-year bull run) with relative underperformance. One cannot expect equity funds to post sterling returns  when the market  itself has given zero or negative returns. At the relative level, we need to do more comprehensive studies to see how many funds are underperforming   relative  to their benchmarks before concluding that it is an alarming picture.  It all depends on which way you look at the data.

For  example,  a recent  study  pointed  out that over the  past five years, over 50%  of equity funds underperformed  their benchmarks.  But the  study looked at the absolute number of funds, and not at the funds in light of their  assets under management (AUM). Consider,  for instance,    a  hypothetical category comprising   two funds  managing INR one billion  (100 crores) and INR nine billion (900 crores) respectively. If one of them underperforms, it means that 50% of the funds underperformed.  However, if the bigger fund outperforms the benchmark, then we can say that 90%  of the AUM outperformed. At the asset level, a preliminary analysis we did over the same time period showed that about 80% of funds (assets) outperformed  their  benchmarks because the more successful funds tend to manage larger assets.

It  is the perception of investors that mutual funds do not give returns. Year on year, mutual funds may perform well, but investors are actually losing money. The number of investors who lose money is greater than the number of investors who make money.

Over the long term,  equity mutual  funds have shown robust performance, but in the short term,  stocks and stock funds can post disappointing  results. It’s the nature of the beast. Investors often tend to have a herd mentality  and flock to asset classes after they have seen years of outperformance  and the markets are at near peaks. The recent mania for gold and for stocks towards the end of 1999 and 2007 are a case in point here; investors entered the markets at precisely the wrong time and burnt their fingers badly.

Then there is also the problem of capital-weighted return.  Suppose a fund  with INR one billion (100 crores) in assets gains 100% in one year. By the end of year one, due to the fund’s stupendous performance and investors chasing it and putting money in it, the asset size swells to, say, INR 10 billion (1,000 crores). Then the next year, the fund returns a negative 50%. In such a scenario,  the net return  at the fund  level would be the same, but far more investor money would  have been lost  as the fund  had fewer  assets when  it gained and more when it lost. At Morningstar, we call the concept “investor  return,”  and in countries  where flows data is available, we often  see a considerable difference  between a fund’s total return and investor return (or the internal rate or return  investors got, capital-weighted)  over any time frame.

In markets  such as the United   States (US), the gap between a fund’s investor return  and total return is often  glaring and remains wide for some volatile categories of asset classes. We would  love to see the difference between the two for Indian funds, but we do not have enough  disclosure  data to calculate it. However, considering that Indian markets are more volatile  than many other  markets  and because, as we mentioned  earlier, investors tend to pour in capital more often than not at the wrong time or near market peaks, we think  the gap would be significantly large.

Until we have sufficient  investor  awareness and disciplined,  buy-and-hold  investing becomes more widespread,  we  will see the  problem   of investor disappointment  manifest itself  even if overall fund performance is good.

 Investors often tend to have a herd mentality and  flock to asset classes after they have seen years of outperformance and the markets are at near peaks.

People in India view insurance only as a means of tax saving. Are mutual funds going the same way? If so, what can be done to prevent such a mindset?

Mutual funds will remain  a push  product   as long  as investors feel more comfortable  with  the 9% stable return  that fixed-income  instruments such as  fixed deposits (FDs) provide. They tend to forget that this 9% return  is often entirely eaten into by inflation  and ignore the higher 20-21% return that the average mutual  fund  has logged over the past 10 years, albeit with greater volatility. .

A big driver  of this growth  could be the introduction   of  mandatory   savings   into  equity products  by the government, something similar  to the 401k in the US (a kind of defined contribution plan to save for retirement). The (National Pension System) NPS is a start, but if we revamped something like the Employees’ Provident Fund (EPF) and partly linked  its returns  to the market,  10 or 20 years down the line, investors would have, out of force, learned the magic of disciplined investing in stocks.

Over  the  course of time,   as investors  develop greater comfort   with equities,  we  will see  more investors come out and buy equity mutual funds.

Exchange-traded funds (ETFs) have not done well in India, whereas they are  popular across the world. ETFs have only about 2% of the market share in spite of their many benefits. Is this due to weak distribution networks and low sales commissions for agents?

ETF is a wonderful  product  as seen by its popularity in the West, offering passive, often  niche strategies for investors  who  focus on asset allocation. But ETFs are far ahead of their time in India. Active management is preferred here, and we do see large outperformances by managers compared  to the West, where beating the market is becoming exceedingly difficult. Further, investing in ETFs in India also has its set of operational issues. One of the challenges for  small investors who do not invest in stocks is the lack of a demat account. To buy an ETF, one needs to open a demat account, and not everyone wants to do that. The point about low commissions  is also one of the key reasons why they  are not  sold  as widely in India.

One argument put forward by some commentators is that if  Indians prefer to invest in gold and real estate, why not give them funds that invest in gold and real estate?

We do have gold funds and ETFs that offer  an excellent  way to invest in the yellow  metal.  Real estate mutual  funds are a different  equation,  however. Asset management   companies   say  they   face practical   difficulties   with respect   to regulations, valuations, and so on.

Who is accountable for the performance of the funds? Do fund managers in India have the necessary qualifications to manage thousands of crores of someone elses money? A person without a background in finance may not be the right candidate to manage funds. What is your view?

As a whole,  we believe that the industry’s assets are in good hands with adequately qualified  people to manage the money. Of course, there will always be times when some managers are outperforming while others aren’t, but that is the nature of the market. If some are underperforming  for a long time,  you will  see investors leaving the fund  and assets drying up and going to better performing managers and funds. It is a self-correcting mechanism. At the ecosystem level, we believe the regulator has drawn  up enough  regulations and put in place processes that safeguard investor interest.

The abolition of entry load and the introduction of direct plans are good moves to help the investor save on expenses and make the product more attractive.

What are  some of  the  things that  the Securities and Exchange Board of India(SEBI) can do to better support the industry? What are the regulatory bottlenecks that keep the industry from growing?

We believe SEBI has done a brilliant job of regulating the industry, especially after  the  2004-2007  boom and subsequent crash when some of the practices were less than ideal. The abolition  of entry load and the introduction of direct  plans are good moves to help the  investor  save on expenses and make the product more attractive.  The regulator  has set the ground  for the industry to grow in a sustainable  manner.  Now, it is left to market performance to pick up and start drawing in more investors, and for investor awareness to increase, all of which will  launch the industry into its next growth orbit. That said, we would like to see a greater focus on independent  research and higher levels of transparency and disclosure in the industry.

You spoke about research. What research topics in this industry would you advise budding researchers  in India to pursue?

If the question pertains to fund  research, I would like to point out the  acute lack of awareness  that exists in India on this subject. For many distributors, recommending  funds means picking  the recent top performers. At Morningstar, our unique  approach, developed through  decades of expertise in the field, is to offer investors not just unbiased and independent but also cutting-edge  research that  helps investors take informed  decisions.

I would  urge budding  researchers to try and stay up to date with the best global fund research practices, qualitative and quantitative, followed by our firm and also our peers. Knowledge,  information  and widening your perspective will  give you an edge over others.

  • Prithvi Raj

    Excellent article, thanks to the authors for this informative article. Good to know that the fund managers are looking into the matter of getting people to invest in the financial markets.

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