An Outlook on the Evolution, Scope and Growth Potential of the Mutual Funds Industry In

Deyvaansh Misra

Contents INTRODUCTION 3 A RETROSPECTIVE VIEW OF MUTUAL FUNDS 5 THE FUTURE LIES ON THE BRINK OF THE HORIZON 6 CONCLUSION 10

INTRODUCTION
Shakespeare once wrote, ‘out of this nettle, danger, we pluck this flower, safety'.
The Indian mutual fund industry has witnessed significant growth in the past few years driven by several favourable economic and demographic factors such as rising income levels and the increasing reach of Asset Management Companies (AMCs) and distributors. However, after several years of relentless growth, the industry witnessed a fall of 8 percent in the assets under management in the financial year 2008-09 that has impacted revenues and profitability. Recent developments triggered by the global economic crisis have served to highlight the vulnerability of the Indian mutual fund industry to global economic turbulence and exposed the increased dependence on corporate customers and the retail distribution system. It is therefore an opportune time for the industry to dwell on the experiences and develop a roadmap through a collaborative effort across all stakeholders, to achieve sustained profitable growth and strengthen investor faith and confidence in the health of the industry. Innovative strategies of AMCs and distributors, enabling support from the regulator SEBI, and pro-active initiatives from the industry bodies CII and AMFI are likely to be the key components in defining the future shape of the industry.
The Indian mutual fund industry has gained immense experience and continues to reinvent itself gradually, exhibiting steady growth over the last decade. A compound annual growth rate of 28% has been recorded by assets under management over the period 2006-10. In today’s volatile market environment, mutual funds are looked upon as a transparent and low cost investment vehicle, attracting a substantial amount of investor attention
The industry is undergoing rapid transformation, with multiple developments taking place on the regulatory front, all ostensibly with the primary objective of protecting the investor and streamlining trading practices to bring in more efficiency. The market participants are in a watchful mood, waiting to see how the industry adapts to these changes. Asset management companies are restructuring their business models in order to sustain the growth momentum of the industry, and provide for increased levels of operating efficiency and investor satisfaction. The industry continues to battle with the challenges of increasing investor awareness, low retail participation, high dependence on the corporate sector and increasing cost of operations. Mutual funds need to play an anchor role in directing the household savings into capital markets.
Assets under management as % of GDP are below 5% in India as compared to 70% in the US, 61% in France and 37% in Brazil. To increase penetration levels of mutual funds, the focus on inclusive growth has taken centre-stage, with all efforts by the regulator and fund houses being concerted in this direction.
It is therefore necessary to reach out to people in Tier II and Tier III cities, which are a daunting proposition considering costs of distribution and outreach and hence planned steps need to be taken to attain some of the long term objectives of financial inclusion. The rising incomes in Tier II and Tier III cities would indicate the latent potential in these cities. It is a matter of channelizing their savings appropriately into mutual fund investments, for which investor education is a necessary first step.

WHAT ARE MUTUAL FUNDS?
A Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal. Anybody with an investible surplus of as little as a few hundred rupees can invest in Mutual Funds. These Investors buy units of a particular Mutual Fund scheme that has a defined investment objective and strategy. The money thus collected is then invested by the fund manager in different types of securities. These could range from shares to debentures to money market instruments, depending upon the scheme’s stated objectives. The income earned through these investments and the capital appreciation realised by the scheme are shared by its unit-holders in proportion to the number of units owned by them. Thus a Mutual Fund is the most suitable investment for the common man as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost.

A RETROSPECTIVE VIEW OF MUTUAL FUNDS

Mutual funds go back to the times of the Egyptians and Phonecians when they sold shares in caravans and vessels to spread the risk of these ventures. The foreign and colonial Government Trust of London of 1868 is considered to be the fore-runner of the modern concept of mutual funds. The USA is, however, considered to be the mecca of modern mutual funds. By the early 1930s quite a large number of close-ended mutual funds were in operation in the U.S.A. Much later in 1954, the committee on finance for the private sector recommended mobilisation of savings of the middle class investors through unit trusts. Finally in July 1964, the concept took root in India when Unit Trust of India was set up with the twin objective of mobilising household savings and investing the funds in the capital market for industrial growth. Household sector accounted for about 80 percent of nation’s savings and only about one third of such savings was available to the corporate sector, It was felt that UTI could be an effective vehicle for channelizing progressively larger shares of household savings to productive investments in the corporate sector. The process of economic liberalization in the 90s not only brought in dramatic changes in the environment for Indian industries, corporate sector and the capital market but also led to the emergence of demand for newer financial services such as issue management, corporate counselling, capital restructuring and loan syndication. After two decades of UTI monopoly, other public sector organisations like LIC (1989), GIC (1991), SBI (1987), Can Bank (1987), Indian Bank (1990), Bank of India (1990), Punjab National Bank (1990) were permitted to set up mutual funds, subsequently followed by private financial enterprises, resulting in an investor revolution. Suddenly the term, ‘stock market, mutual funds, savings bonds’ became household commonalities.

Today, the industry stands at 38 asset management companies that manage Rs. 7.1 trillion (USD 160 billion) of Assets under Management (AUM) raised from around 470 million accounts. Since the economic liberalisation of the early nineties, mutual funds have been regulated by the securities market regulator, Securities and Exchanges Board of India (SEBI), which was itself a very new regulator in the early nineties. At the time, like all the other parts of the financial sector, the industry was lightly regulated with low levels of transparency about the management of funds. It was only in 1998, after a spectacular episode of market misconduct by the CRB group of companies that there was a sea-change in the regulation and supervision of the mutual fund industry. The regulator focussed on the production end of the mutual fund industry. This resulted in very high disclosure and transparency of the assets under management and improving the governance of the AMCs, setting it apart from the rest of the fund management industry in India. This path towards greater transparency became the industry norm when UTI, the only AMC that was exempt from full transparency on certain products, developed problems in fulfilling obligations to customers. As part of the government bailout package in 2001, the AMC was broken up into two funds. One had a fixed mandate of winding down upon completing the obligations of the original UTI schemes (primarily US-64) to existing customers. The other was a company where the government was one of other shareholders that would follow all the regulation of the other mutual fund companies. With this, the mutual fund industry became the only fund management industry in India with a minimal presence of public sector ownership. Since then, there have continued to be changes in the regulation of mutual funds, but largely driven by developments in the broader securities markets. The rules-driven regulatory framework in India has meant that innovation in the securities markets often drives change in the rules on how mutual funds can access these innovations in offering new products to their customers. However, regulations governing the fund management process have been more or less stable, albeit conservative.

THE FUTURE LIES ON THE BRINK OF THE HORIZON
Quite easily the most important aspect for the MFI will be retail investor participation. Though the appetite of retail investors in India for participating in the country’s growth story remains to be satiated in a big way on the part of investors, over a medium to long term horizon, the investors are well aware of the equity markets showing signs of having good potential for capital appreciation.
Participation in the mutual fund industry remains skewed towards the corporate investors, involving low participation from the retail sector. As of March 2010, the corporate sector contributes around 51% of the total assets under management, while the retail segment contributes only around 27% of the total assets under management, which is a slight increase from 21% reported in the previous year.
Investor confidence in the securities market took a beating during the downturn, and since the course of the mutual funds shadows that of the capital market, investors also lost faith in mutual funds, leading to a lot of redemption pressures for fund houses. Investors should be encouraged to migrate to mutual funds from other traditional modes of investment and should be prepared adequately to take measured risks. One of the reasons why mutual funds have failed to cultivate the confidence the investor is that most often, the risk attached to the product is “under wraps”. Thus, the long term benefits of remaining invested in these funds over a long term horizon are lost on the investor. The result is that, a product designed for a small investor fails to foster a market for itself. Implementing disclosure practices is likely to lead to increased transparency, which may result in increased confidence of the investor.
Capital markets in India, perceived as part of one of the fastest growing economies, have caught the attention of global investors. Foreign investments have poured into the country, with around $20 billion ploughed into the capital markets in the period January 2010 to November 2010. In March 2010, the number of SEBI registered FIIs went up to 1,713 from 1,635 a year ago. Their net purchase in equities was $23 billion in 2009-10 against net sales of $10 billion in the previous year. The total net inflow of FII was Rs.1,427 billion ($ 31 billion) as against an outflow of FII of Rs.458 billion ($10 billion) in 2008-09.
Part of the SEBI rationale for explicit disclosure of distribution commission has been in reaction to the abuse of such practices in other areas of financial fund management in India, at the expense of the investor. Also, SEBI's regulations (to trade MF products on exchange, make transparent distribution costs) seem to be on track with respect to the larger global trend is towards greater transparency. All of this is being done to achieve an increased retail participation in mutual fund products over the medium and long term horizons. However, increased retail participation is not driven by lower costs of participation alone. An illustrative example from within India is the New Pension System (NPS). The NPS was designed with the explicit aim of providing a transparent and low cost pension product to any citizen in India. While the end system has evolved differently from the original design, the NPS does adhere to being one of the lowest cost fund management systems.

One the greatest bottleneck perceived is that of a lack of investor awareness. If this is true, then how can investor awareness about the mutual fund products be improved?
In this, what is the role of the (a) regulator and (b) the mutual fund industry to promote this need?

Presently, it is the distribution agents" that make investors aware of products available in the financial sector, be it mutual funds or others like insurance. However, the services they provide range from high valued financial advisory for high net worth individuals to agents that are only responsible for the collection of cheques from customer for delivery to the AMC. There is no standardisation of the role specification of the distributor. They have no accountability with regards to the services they provide to the investor, or to the AMC. This had led to wide-spread incidence of unethical selling of products across all financial products, across all countries, where the objective of the sale has been to maximise the revenues from the sale rather than to ensure a match between the needs of the investor and the product offered by the AMC.

That context raises the following questions: 1. Can the existing set of distributors play a greater role in improving investor awareness towards using mutual fund products (or indeed, any financial product) for financial planning? 2. Can the creation of a financial advisory channel/transition of the existing distribution agents towards financial advisory services be done by the financial companies themselves? 3. What is the role of regulation in the creation of such a channel? 4. Since the financial advisory channel must ideally span different financial products (which currently are under different regulators in India today) what is the optimal regulatory involvement to govern the creation and regulation of the financial advisory channel?

A common feature of all financial products available in India today is that there are very few simple and easy to understand products (this is true for mutual funds as well). Given the limited space of assets based on which mutual fund products can be created, there is perhaps a limit on the risk-return choices that can be offered by various fund managers. Therefore, the differentiation across products comes in the form of either (a) bundled with other financial products like insurance or (b) carries additional optionality of and upon exit. This is typically specified as fine-print on the product specification. The complexity that this introduces in understanding products becomes a serious impediment to customer participation. This is enhanced when the customer base has low investment awareness.

The question that needs to be visited is:
Why is there so little product simplicity in the mutual fund space, or indeed any financial product space, in India?
Is there any role for regulation to play in bringing about more simplicity of mutual fund products?

Another bottleneck is that of better investor access. One easy way to visualise this problem is the minimum amount that is required before an individual investor can save using mutual fund products. What is the role of the (a) regulator and (b) the mutual fund industry to promote access to mutual fund products?

A couple of issues fall under the question of access:

1. Account opening procedures (for instance, the recent KYC requirements for the investors can be onerous to the small retail investor).
2. Minimum size of investment (several products have minimum investment sizes that place them out of the reach of small investors.

How much of the poor retail participation in mutual funds is caused by the lack of a level playing field" between different fund management choices available to the Indian investor today?

But in the interim while it is operational, what can the SEBI/market participants do to resolve these differences? What role can the foreign fund management industry play in this process of developing the fund management industry in India?

In the past two decades since the start of the economic liberalisation, foreign participation has played a significant role in the development of the finance industry, either through example, or by providing competition to the domestic industry. The fund management industry all over the world is going through a series of reforms similar to the Indian industry. This is particularly true in the area of evolving different business models that frontally attack the issues of improving investor awareness and more transparent distribution of products through the development of a range of financial advisory services.

CONCLUSION
It remains implacably clear that the existential dilemma posed by the rapid growth of mutual funds, need for stronger retail participation and the growing importance on India are all indicators of a wide ranging and diverse MFI future portfolio. Personally, we believe that the time of the investor has dawned, and it is only a matter of time when the ubiquitous common man is an experienced investor. But amidst the regaling there needs to be a strong word of caution. Let us learn from others’ mistakes and develop a sound regulatory framework that avoids the bane of investor manipulation and exploitation.