The Hindu Business Line : Minor variations, no real mutual benefits

THE number of equity funds in the country has risen handsomely in 2004-05. As of December 2004, the industry managed 140 schemes with an asset size of about Rs 31,500 crore. That is up from 128 schemes managed in April 2004.

Fund houses continually introduce new schemes to increase the assets under management (AUM). The problem is that the number of schemes available in the market has a direct bearing on the asset price efficiency. That is, more the number of equity funds, the higher the asset price efficiency, as portfolio managers strive to generate differential returns among minor-variant products.

Higher asset price efficiency will make it difficult for portfolio managers to beat the benchmark index and peer funds. So, fund-houses may find it hard to justify the high fee structure and loads.

At the extremes, high net worth individuals and small investors with access to private information may shift from mutual funds to direct investing. For this class of investors can score on market timing and lower impact cost. It is time the mutual fund industry realised this and desisted from introducing products that are minor variants of existing ones. In a game-theoretic sense, introducing such minor-variant products should not be the dominant strategy of the fund houses.

Product optimality: Tata Infrastructure Fund was launched in December 2004. The fund mobilised Rs 750 crore, according to the data provided by the Association for Mutual Funds of India.

As the name suggests, this fund will invest in companies in the infrastructure sector. But so can the Tata Pure Equity Fund and the Tata Equity P/E Fund. So, why introduce a fund to cater to an industry sector?

At present, the portfolio fee is a function of the AUM — higher the AUM, higher the fees. Tata Mutual Fund is not alone in this strategy. Fund houses have learnt through experience that increasing AUM is easier through minor-variant products. But such an investor psyche may not last for long. Here is why.

When more equity funds are available in the market, money flow into these funds will depend on performance. And performance will be largely driven by security selection at the portfolio manager level. As more money flows into the market, asset mispricing will be aggressively arbitraged away. This essentially means that the portfolio managers will have to strive harder than ever before to beat their benchmark, unless they rely on market timing.

Investment universe: The reason market timing will play a crucial role is because of the universe of investable stocks. Fund-houses typically look at stocks in the S&P 500 Index universe. The correlation between the S&P CNX Nifty and the S&P CNX 500 indices is 0.93. That is, indeed, high considering that the Nifty contains only one-tenth of the total stocks in the S&P CNX 500 index.

This piece of statistics throws some light on the problems that portfolio managers' face. First, portfolio managers can outperform the broad benchmarks if they exploit the non-correlated space in the S&P 500 universe. And, second, they can outperform through market timing. It is moot whether portfolio managers may be able to consistently beat the benchmarks through these strategies in the light of the increasing asset base.

Studies in the US have suggested that it pays to buy index funds rather than active funds because the latter on an average under-perform the benchmark. One reason for such a conclusion could be the size of the industry.

According to the statistics given by the Investment Company Institute, there are roughly 5,000 equity funds in the US managing an asset base of $ 4,222 billion. Together, these funds constitute a fifth of the market.

In India, mutual funds still constitute a small proportion of the market. Perhaps, this factor helps the portfolio managers outperform their benchmark. But such out-performance may be difficult as the industry expands its AUM and asset price efficiency improves.

Perhaps then, fund-houses will be hard-pressed to introduce innovative products to generate portfolio alphas. Till then, minor-variant products will be the order of the day.

(Feedback can be sent to bvenky@thehindu.co.in)

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Give full freedom

Poetry and business

The fine art of Budget-making

Indian corporate finance deals — International private equity investors dominate

Minor variations, no real mutual benefits

What kind of a central banker do we need?

To take on competition, Air India must expand — Mr V. Thulasidas, Chairman and Managing Director, Air India

FII investment trends

Opportunity for honesty