Aarati Krishnan

A retrospective of mutual funds @25

aarati krishnanCircuit Breaker | Updated on July 19, 2018

The industry has come a long way and MFs are now the sahi option for investors but it’s still work-in-progress

It is a fitting tribute to the silver jubilee of private sector mutual funds in India, that retail investors should be finally convinced that mutual funds are the sahi option for their needs.

After taking 20 long years from 1993 to 2013 to expand assets under their fold from ₹48,000 crore to ₹7 lakh-crore, Indian MFs have effortlessly trebled their assets to over ₹23 lakh-crore in the last five years. Nearly ₹70,000 crore of the annual MF flows now flood in through the Systematic Investment Plan (SIP) route. Getting to this point where SIPs occupy top-of-mind recall for newbie investors, rivalling old favourites such as insurance plans or bank deposits, has not been easy.

The hits

For this, the credit must go to asset managers, intermediaries and the regulator in equal measure. Three positives of the MF industry are worth recounting.

One, at a time when fund managers in the developed markets have floundered in keeping up with markets, active fund managers in India have convincingly outperformed benchmarks over 5, 10 and 20-year time frames. Despite recent hiccups, the 10-year category returns on actively managed large, mid and small-cap funds are ahead of the Nifty50, Nifty Midcap100 and Nifty Smallcap100 by convincing margins of 100, 300 and 700 basis points respectively. This is no mean feat and has ensured that older MF investors have reason to steadily raise their allocations. The dominance of open end funds has also made sure that poorly performing ones lose assets to winners.

In India, financial intermediaries usually have no qualms about saddling uninformed investors with flawed products that yield them sky-high commissions. But a majority of MF intermediaries today have stayed the course to service investors, despite constant pressure on their fees, increasing regulations and a widening regulatory arbitrage with other financial products.

The emergence of third-party rating agencies and online distribution platforms have greatly simplified the MF investors’ life too, both in transacting and monitoring performance.

SEBI has also proved to be a strong regulator, constantly prioritising investor interests. SEBI’s progressive tightening of its rules on disclosures, prudential exposures and governance has played a key role in establishing MFs as the go-to product for investors seeking a simple, liquid and transparent vehicle.

The misses

There are some misses worth recounting too.

Short-termism: The Twitter feeds of MF honchos may be full of thoughtful quotes about the virtues of long-term investing. But the industry doesn’t wholly practise what it preaches.

For one, MFs are still marketed on their recent 1-year, 3-year or 5-year records. AMFI data tell us that, even as recently as March , 56 per cent of retail investors had a less than two-year holding period on equity funds. That’s scarcely any time to reap the rewards of equity investing.

Two, with investors and AMCs displaying very little patience with managers who fail to ace their peers on a quarterly basis, fund managers are prone to short-termism too. A majority of domestic equity funds sport portfolio turnover ratios of 50 per cent or more, a sign that at least half the stocks are replaced in a year.

Three, fund managers seem to be afflicted by the same short-termism with respect to their careers too, with very few sticking to one AMC long enough to demonstrate a credible track record.

This makes it tough for investors to give much credence to an MF’s past record.

For the industry to attract better managers and more sticky assets, it needs to shift the goalposts to more long-term performance measures. Pay packets for fund managers must reward consistency and tenure, rather than the ability to ace 1 or 3-year rankings.

Lack of innovation: It is striking how little present-day products have moved beyond those ushered in by the first set 25 years ago. Equity MFs in India are still classified on the basis of a single-dimensional market-cap approach — an idea pioneered by Kothari Pioneer Mutual Fund in 1993. Debt funds are still tailored more to corporate treasuries than retail investors. While there’s an army of active funds, good passive funds and ETFs are missing in action. New launches in recent years have centred around generic close-end funds, thematic funds, or products like equity savings funds, designed to exploit tiny loopholes in ever-changing tax laws. Instead, investors would love to see 10 and 15-year debt funds, pension funds that deliver tax-efficient income or ETFs with micro-cap or broad-market portfolios.

Playing it close

After setting a high bar on liquidity and disclosures with their open-end funds, MFs have been regressing lately, by rolling out series after series of close-end funds with vague mandates. Close-end schemes at 1,002, now far outnumber open-end schemes (811).

AMCs argue that investors can reap better returns from the stable corpus and lock-in rules of close-end funds. But their limited launch windows subject investors to big timing risks. As most close-end schemes manage a tiny corpus, their fees are high with no penalties for non-performance. Close-end schemes are also exempt from SEBI’s skin-in-the-game rules that require AMCs or sponsors to invest their own money in the schemes they manage. Close-end funds also escape from SEBI’s recent categorisation and truth-in-labelling rules.

If the investor experience with these close-end schemes turns out to be poor, that can decimate the reputation that open-end funds have taken well over two decades to build.

Shrinking competition

It may seem odd to fret about shrinking competition in an industry with 40-odd players and nearly 2,000 schemes. But the truth is that the industry is increasingly becoming a five-horse race. The top five AMCs in the industry today control a whopping 57 per cent of the assets. This list has seen hardly any change over a decade, with large AMCs simply growing larger.

The domination of bank-sponsored AMCs, nudging out pure asset managers and foreign players, has resulted in a cosy nexus between the large AMCs and their bank sponsors, who function as their biggest distributors too. New fund houses, even with good 10-year records, have found it tough to break into this clique. The low capital intensity and easy scalability of assets also gives large players the clout to stomp out competition through high-decibel advertising and below-the-line distributor incentives. Of late, a new worry for investors is spectre of related party deals between AMCs and their numerous siblings under the same sponsor.

In its own interest, it would be good if the MF industry self-regulated on these aspects, without waiting for SEBI to add a few more pages to its already fat rule-book.

Published on July 19, 2018

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