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Mutual funds face a moment of truth


“I have seen people in my family investing in mutual funds over the past 10 years and not get much of a return. I do not trust the process by which the fund manager is selecting stocks to buy,” he added.

Large-cap mutual funds have delivered an annual return of just 8.36%, on average, over the past decade, according to data from Value Research. Their mid- and small-cap peers have delivered 9-11%, which is only a short distance away from the 8% that was offered on bank fixed deposits (FDs) and public provident fund (PPF) at the start of the decade. The problem becomes more acute if we look at more recent 3- and 5-year returns.

The uptick in disillusionment with India’s 25 trillion mutual fund industry is rooted in a variety of reasons: poor returns; increased consumer wariness following the sudden closure of a slew of debt funds managed by Franklin Templeton; other investment opportunities in gold and direct stocks. Clearly, the heady few years of growth witnessed by the mutual fund industry—following the sudden inflow of funds into the banking system post-demonetisation which depressed FD rates—may now be at an end.

Net inflows into equity funds, a widely tracked metric, fell to a 4-year low in June 2020. In July, it entered into negative territory. The monthly systematic investment plan (SIP) figure, a backbone of the industry, has also plummeted. The year 2020 is a black swan for the industry—a severe recession in the economy combined with poor long-term returns in the equity space. It may have just created the perfect storm.

Boom and bust

India’s mutual fund industry, much like life insurance, was once dominated by a single public sector entity—the Unit Trust of India (UTI), which was established by an act of Parliament in 1963. UTI was joined by a handful of private sector players after 1991. The industry saw two boom and bust cycles in the years before demonetisation—first with the dotcom bubble and second after the long boom between 2003 and 2008. The global financial crisis of 2008 however brought this second major expansion to a halt. The industry didn’t recover from that shock for another six years.

“Till 2014, sales were mostly negative and money flowed into other asset classes like real estate and gold,” said Vijai Mantri, co-founder and chief investment strategist, JRL Money.

But within a few months after the first-term election of Narendra Modi, mutual funds entered the third and strongest-ever growth phase. New investors entered the industry as enthusiasm about reforms gripped the market. Then, demonetisation in 2016 pushed a tidal wave of money into banks and compressed fixed deposit rates, forcing investors to search for higher-yielding alternatives. Mantri credits this as the largest growth phase for mutual funds in India.

The industry body, Association of Mutual Funds in India (AMFI), was quick to capitalise on this, launching the Mutual Fund Sahi Hai campaign in March 2017. It is this third expansion that the growth stagnation of 2019 and the covid-19 crisis of 2020 have brought to a grinding halt. Coupled with the self-inflicted wounds of risky lending and falling equity fund performance, this has become the hardest test yet for the industry’s vigour.

The fate of the mutual fund industry is closely tied in with the performance of India’s equity market. The latter (as measured by the Nifty) has delivered a compounded annual return of around 9% over the past decade, 7% over the past 5 years and about 5% over the past 3 years. Given that a large number of fresh investors only came in 3-4 years ago, the more recent slowdown is likely to leave a strong psychological impact. Actively managed funds have failed to keep up with even these lacklustre index returns.

The SPIVA report for December 2019 compiled by S&P Dow Jones showed that only 35% of large-cap funds managed to beat their benchmark indices over the last 10 years. Around 20% of the industry’s equity assets under management sit in such large-cap funds and another 20% sit in multi-cap funds which are mostly large-cap oriented.

Kaustubh Belapurkar, director, fund research at Morningstar, spelt out the connection. “Investors tend to look primarily at past returns while investing. Past returns for equity funds over the last 3-5 years have not been great. In order to get back to the growth of say 2016 or 2017 in the industry, we will have to see a major bull market in stocks and returns turning positive in a big way,” he said. Vidya Bala, co-founder of Prime Investor added one more ingredient to the list–a recovery in India’s real economy needs to happen after the covid-19 shock. “Fund houses have spotted the challenge and I think that is why many of the new launches are passive ETFs tracking the market rather than active funds,” she said.

Passive funds merely track indices and bring in lower revenues to the industry than active funds. Despite the unpleasant near-term outlook, Bala took a sanguine view on one category of funds: debt. “On the debt side, I don’t see a major challenge because there is a lack of tax-efficient, better return yielding alternatives to debt funds/debt ETFs,” she said.

The view of experts stands in stark contrast to a series of debacles in debt funds, starting with the IL&FS crisis in September 2018. In the following two years, other defaults or downgrades have emerged, including DHFL, Reliance ADAG Group, Essel Group, Vodafone Idea, Yes Bank and Altico. The shock closure of six schemes by Franklin Templeton affected 300,000 investors. But unlike equity, debt continues to be dominated by corporate treasuries which take a hard-headed view of the product. After panic redemptions in late April and early May, debt fund flows have recovered, particularly in low-risk categories such as banking and PSU debt. Anecdotally as well, media reports about Reliance Industries deploying money from recent stake sales into debt mutual funds suggests that corporate confidence is largely intact. Much of the debt story thus depends on whether the prevailing tax advantage over bank FDs will continue. Long Term Capital Gains (LTCG) on debt funds are taxed at 20% and given the benefit of indexation, while FD interest is taxed at slab rates.

The competitors

While another bull market is a necessary condition for the industry to see rapid revival, it is not sufficient. All along, mutual funds have had competitors in the equity space. Foremost among them are the brokers who provide research to retail investors and earn commissions from their stock transactions.

The two industries have developed synergies, with brokers selling mutual fund schemes and mutual funds paying brokers for their research and broking services. But essentially, SIP money is money that does not go to a broker to advise upon.

Amitabh Kant, CEO of Niti Aayog, recently took to Twitter to congratulate India’s largest brokerage, Zerodha, on its rapid growth during the lockdown period. India’s latest breed of stock market investors prefer to do it themselves rather than hire a fund manager. Stockbrokers on the National Stock Exchange added 2 million active clients in FY 2019-20, but their growth moved several gears up in FY 2020-21 when they added a whopping 800,000 active clients in just the first two months of the new financial year. New startups like Smallcase also allow investors to construct portfolios around themes or ideas, which is essentially the job of a mutual fund.

Broking is not the only industry snapping at the heels of fund companies. Another prominent one is Portfolio Management Services (PMS). In its essence, a PMS does exactly what a mutual fund does—manage a portfolio of stocks or bonds, but with fewer restrictions. It’s marketing and sales have been restricted to the affluent by a 50 lakh minimum threshold, but that doesn’t stop it from luring away a big chunk of money from mutual funds.

“Smart money has been moving to equity PMS for a while now,” said Vikaas Sachdeva, CEO, Emkay Investment Managers Ltd. “Unlike MFs, PMS have more investment elbow room due to the end customer being savvier, and hence, it is subject to a lot fewer constraints. From a client point of view also, there is a sense of stock ownership since scrips are credited and debited from their own demat accounts. This is simply not there in an MF,” he added.

PMS also has an ace up its sleeve—hefty commissions. Unlike the Total Expense Ratio (TER) of a mutual fund, there are no explicit fee caps on PMS products, allowing far higher commissions to be paid out. In February 2020, SEBI banned upfront commissions in PMS and asked providers to give a commission-free ‘direct’ option to investors, just like in mutual funds. However, despite these restrictions, PMS remains a relatively lucrative product for distributors.

A third large competitor is insurance, particularly investment products sold as insurance policies such as Unit Linked Insurance Policies (ULIPs). The commissions on insurance policies are significantly higher than mutual funds despite a gradual clampdown on them by the insurance regulator, IRDAI. The insurance industry also enjoys the advantage of zero tax on returns for policies which meet certain criteria, which even equity mutual funds cannot match. This is because Budget 2018 levied a 10% LTCG on hitherto tax-free equity mutual fund returns while leaving insurance untouched. There are also around 20 lakh life insurance agents in India, compared to around 1 lakh mutual fund distributors. The success or failure of any financial product depends to a large extent on distribution.

In conclusion

Poor equity performance, competition from brokers and PMS and a weakened distribution network have created a perfect storm for the mutual funds industry, which will need to reinvent itself.

The approaches taken by some fund houses may indicate a way forward. One method is to drastically cut down on the number of schemes and focus on 3-4 core schemes where the AMC in question has domain expertise. This can keep down costs and build a brand in specific areas. Parag Parikh Financial Services (PPFAS), a small but feisty mutual fund follows this model. Despite a 7 year history in the AMC space, it has only launched two equity schemes and one liquid scheme so far.

In a marketplace where there are around 40 fund houses and 2,000 schemes, a simple approach can also help declutter the minds of investors and avoid the perception that schemes are being launched just to gather assets. PPFAS has recorded one of the fastest growth rates in the industry, nearly doubling its average assets under management from 2,116 crore in April-June 2019 to 3,600 crore in April-June 2020. Another AMC, Mirae Asset also follows a variant of this approach. It has rapidly grown its assets in the past 3-4 years without distribution support from any associate bank.

Another lucrative idea that is gaining traction is to embrace global investing, an avenue that the industry has largely ignored over the years. The US markets, in particular, have notched up huge outperformance over their Indian counterparts in the past decade. Individual investors can directly buy stocks abroad through the RBI’s Liberalised Remittance Scheme but this is a cumbersome and costly procedure for small investors, giving funds a natural advantage. Without such innovations, the future looks highly uncertain.

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