Are mutual funds ready for foreign investors?

The Finance Minister gave the mutual fund industry a gift in Budget 2011: Foreign investors we were told, could invest in Indian equity mutual funds subject to fulfilling “Know Your Client” (KYC) requirements. Your American pen pal, your British colleague, the Spanish girl your NRI cousin married…all of them can now be a part of the India growth story through our funds…or can they? Is this really a giant orchard of “low hanging fruits”?

Past experience makes me wonder how it will shape up in the implementation. In the past, attempts by the Finance Minister to open new markets for the mutual fund industry have not always been successful.

For instance, about a decade ago, it was decided that provident funds would be allowed to invest in mutual funds that invest exclusively in government securities (GILT Funds). A total of 47 mid/long-term Gilt Funds exist today, of which 31 have a corpus of less than Rs 50 crore, 8 have less than Rs 1 crore and the industry manages just Rs 3,402 crore in this category (Source: Value Research).

This was largely because of a gap of many years between the Finance Ministry's notification and the approval by the Labour Ministry. By the time the approval came, the business case for investing in gilt funds was weak. The current interest rate environment may provide an opportunity, once more.

Then there was the provision to allow Indian investors to remit up to $200,000 abroad, which was seen as an opportunity to offer offshore investment products. After lots of business plans, the net result, to the best of my knowledge, has been that there are few ways to use this route to invest abroad. More recently, there was a provision enabling pension and provident funds to invest 15 per cent of their incremental flows into equity, including equity mutual funds. This has not really translated into action on the ground, and very few provident funds take the call.

Reciprocal passporting

Therefore, while this journey of a thousand miles to foreign shores has begun with a single important step, there is still a bit of distance left to cover.

Indian mutual funds cannot sell our products to foreign retail investors in most countries. It would require our mutual fund to re-cast offer documents to suit the

requirements of the regulators of that country, without violating SEBI norms, and then file for registration with the local regulator. Some countries permit reciprocal passporting (portability between borders); that is, if Country X allows Country Y to sell its approved mutual fund schemes in Country X, Country Y will reciprocate.

Thus Hong Kong registered schemes can be passported to Australia, by a simple filing and vice-versa. In Europe, investment funds can be offered across borders under the UCITS framework.

If we allow other IOSCO (International Organisation of Securities Commissions) countries to benefit from the $200,000 route by allowing passporting of their schemes on a reciprocal basis, we can sell our schemes to retail investors in those countries.

A question then comes up as to whether people can just google up Indian mutual fund Web sites and invest through them. In theory yes; but most regulators do not take kindly to people enticing retail investors by this route and are likely to ask us to desist.

Even today, many international fund houses that operate in India, do not allow NRIs to invest into their schemes (though this is allowed as per our rules) if the NRI resides in the US, the UK, Singapore, Canada, and so on, because they don't want to risk regulatory censure in those countries for allowing purchase of non-registered products.

The only major geography that is an exception in this regard is the UAE, where a registered intermediary can sell any of our mutual fund schemes. This market could open up, especially because of familiarity with India and the number of Indian advisors already there.

Commercial challenge

Besides the regulatory challenge there is the commercial challenge. Most countries allow loads of around 4-5 per cent for retail investors and intermediaries are used to receiving that income. Even if we meet regulatory requirements, the commercial one would be tough to overcome in the current regulatory framework.

Let us look at institutional and wealthy investors. Many countries that do not allow retail sales of non-registered funds do allow limited sales, usually defined as a private participation by less than 50 individuals or entities, investing large amounts (“sophisticated investors”). Conditions include not indulging in any broadcast marketing such as spreading around sales literature and offer documents. This market is easier to access, but this is an extraordinarily well-advised and price-sensitive market. Given the current rules that prevent differential pricing or having “super institutional plans”, very large investors may find our 2.5 per cent fees unattractive. Many of the large financial institutions abroad already have FII registration in India or are working through existing FIIs, local advisors and/or P-notes.

Withholding tax is another hurdle. Currently, while dividend income from equity funds is tax-free, we have to deduct 15 per cent as withholding tax from remittances to NRI investors for short-term capital gains from equity mutual funds. That is a serious deterrent, because though some NRIs file returns here…no foreigner would.

KYC compliance

Finally there is the KYC requirement. India is particularly sensitive to the nature of funds flowing in from abroad. Given the shifting political situation in the Arab world and increased European and US scrutiny, there is an opportunity to bring huge money into our funds, regardless of the foregoing hurdles… but would we want that money? In a nutshell, the ideal way to encash this opportunity and attract legitimate investor interest from abroad would be if the regulators quickly build up the enabling conditions. These include more flexible pricing of mutual funds, clarity on withholding tax and allowing passporting with select IOSCO countries.

For the time being therefore, it may be worthwhile for mutual funds to focus on foreign investors which are already investing in India via P-notes and offer them our index funds as cheap baskets of stock. Since the P-note route is pretty well regulated now, the institutions using P-notes would easily meet our KYC norms and may like to get an actual stock purchase rather than a derivative instrument.

This would perhaps be a good way of honing our skills in international marketing and building awareness among international distributors about ourselves, while we wait for the current market to transform the Finance Minister's gift into a workable new market for our funds. I think with a regulator who has been on both sides, we are more likely than ever before to have hope of this happening soon.

Regulations in other countries, differing load structures and lack of clarity on tax may be some of the hurdles to foreign investors looking to invest in Indian funds.

(The author is MD and CEO, IDBI Asset Management Ltd. The views are personal.)

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