Learn to perform

Last Updated: Sun, Jul 22, 2012 18:42 hrs

The measures suggested by the Securities and Exchange Board of India’s (Sebi’s) Mutual Funds Advisory Committee to help revive the mutual fund industry may be misdirected. Unquestionably, the Indian mutual fund industry is in the doldrums. Penetration is concentrated — about 73 per cent of assets under management (AUM) are located in the five metros and 87 per cent in the top 15 cities. AUM has fallen over the past three fiscal years. It was roughly 6.5 per cent lower in June 2012, compared to March 2010. The RBI data suggest mutual fund investments as a percentage of household savings have been negative since 2010-11, implying lower household allocations and capital losses. The Sebi committee suggests that a more liberal expense ratio, especially for operations outside the top 15 cities, may help asset management companies (AMCs) increase penetration. Also, a provision where exit loads are ploughed back into funds (rather than going to the AMC’s balance sheet) will boost value for long-term investors, who buy and hold. The latter is true.

But, rather than asking for a higher expense ratio, the industry’s real need may be introspection about the efficiency of its own operations. Expense ratios are already very high in India, roughly ten times the norm in developed equity markets. Since India is a high-volume, well-developed equity market with very low brokerage, the rationale for even higher expense ratios seems weak. There are 44 AMCs, each offering multiple schemes. In theory, competition should lead to lower expense ratios. Also, why have mutual funds failed to penetrate into smaller towns? Fast-moving consumer goods and white goods majors, banks, credit card issuers, car makers and telecom companies have all substantially increased their presence there.

One reason for falling AUMs and capital losses is overall bearishness. Equity investments (and debt as well) have given meagre returns in the past two years, making already-conservative households even more risk-averse. However, households hold a larger share of financial assets in direct equity investments and in unit-linked insurance plans (Ulips) offered by the insurance industry (which gives far higher commissions). Investors with risk appetite invest directly in equity while agents prefer to hard-sell the more lucrative Ulips to the risk-averse. This arbitrage where the agent has more incentive to sell Ulips is a problem area. It cannot be addressed without sparking a turf war between regulators. Surprise at the underperformance of benchmarks by most actively managed funds is strange; it merely reflects global trends. Global statistics strongly buttress the case for passive index-based investing, with low expense ratios, as laid out in the efficient markets hypothesis. As the Indian market becomes more efficient, actively managed funds will always underperform as a class. A fund that charges higher expense ratios is even more liable to underperform. The Indian mutual fund industry will simply have to find ways to restructure, market and sell its products to face competition from insurance, if the arbitrage remains. Changing the risk-averse matrix of household asset allocation won’t be easy either. A turnaround in the stock market trend may help. But higher expense ratios probably won’t.

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