So far so good, but it’s time for more sophisticated products
The extent of outperformance over benchmark indices is narrowing down with increasing sizes but is still commendable
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This has been a phenomenal year for the mutual fund industry. There has been a meaningful expansion in equity flows, number of folios, systematic investments, beyond-top-15-cities (B15) applications and assets under management. In all these parameters, the addition was what the entire size of the industry was a few years ago. We are witnessing a J curve effect decades after the foundation was laid by the Securities and Exchange Board of India (Sebi), distributors and asset management companies (AMCs). Fund performance has been mostly reasonable across debt, equity and hybrid categories.
The extent of outperformance over benchmark indices is narrowing down with increasing sizes but is still commendable.
In 2016, mutual funds mostly allocated capital efficiently—good governance was rewarded with better valuation; lack of governance was denied capital. Many companies that have borrowed thousands of crores from banks were not able to raise money from mutual funds through stocks or bonds. The way mutual funds allocate capital is improving governance practices in India Inc. But the overall growth has been imbalanced. The gap between small, medium and large fund houses is widening in favour of large fund houses. Big are becoming bigger and small are becoming irrelevant.
However, the distribution base is not expanding at a pace that is required to reach out to millions of untapped customers. And this is when the cost of acquiring a new client in mutual funds is far lower than it is for a bank or an insurance company.
The industry follows superior practices than peers in portfolio disclosure, valuation, charging expenses and recognising underperforming assets. Being able to pass on market volatility to customers on a daily basis, it does not need an implicit guarantee of the government, as some peer industries need.
In 2016, mutual funds proved they could be a low-cost, compliant and transparent entity to channelize savings towards financial investments.
In this regard, credit goes to Sebi for building a regulatory framework over the years that pushed for accountability, transparency, inclusion and performance in mutual funds. There, however, remains multiplicity in schemes across various categories, which not only confuses clients and distributors but also creates an uneven playing field between small, medium and large fund houses. Larger fund houses have more schemes, which allows them to have different portfolios across duration, credit, sector and capitalisation buckets.
It is these different portfolios, rather than investment views, that generates returns. Many clients buy looking at the scheme performance rather than the overall performance of the fund house.
Sebi has been pushing for consolidation of schemes. In 2016, there was extensive interaction with mutual funds over this; 2017 should see some final action.
There is also an urgent need to standardize definitions of asset classes. For instance, some balance funds have equity allocation capped at 90%, some at 70% and some at 50%. Even Usain Bolt will not participate in a race where he has to run a 100-meter hurdles race while others have to run a 50-meter normal race. Such a mis-match persists across short-term, mid-cap, sector funds and other types of funds as well.
Sebi had brought in a standard definition of maturity for all liquid funds after the 2008 financial crisis.
Fund managers have to justify their existence by outperforming benchmark indices. Till 2016, most Indian fund managers have created an outstanding track record. It is so good that even legends like Warren Buffett or Peter Lynch will be proud to own it and fear to compete against it. However, in the past few years AUMs have multiplied. Maintaining performance on this size is like expecting Sachin Tendulkar to play at 40 years of age the way he played in his prime.
There is a real danger that fund managers will get trapped in a vicious cycle—flows getting invested in existing holdings, the holdings’ price appreciating due to the constant buying, and better performance bringing in even more flows. And one day, when valuations overcome flows, investors will suffer.
It is important to accept that with size, a fund manager needs different tools to generate performance. The time has come to liberalize derivatives rules for Indian fund managers. They must be given flexibility to manage risk. The equity futures limit for mutual funds has been Rs150 crore since 2006, even though fund size and equity prices have multiplied.
It’s also time to introduce higher-risk-higher-return categories of products such as long short funds, leveraged funds, hedge funds, commodities funds, and others, for non-retail investors. Such products will, of course, require appropriate regulatory frame work and supervision. But it is important to introduce such products so that the industry can attract and retain talent for the future. We need to ensure that K.L. Rahul, Karun Nair and Ajinkya Rahane are there to take over when Sourav Ganguly and Tendulkar hang their boots.
With the talent pool in India, we must aim to make Mumbai a regional asset management centre like Singapore or London. To reach there, it is important to make our markets vibrant and deep. Introduction of sophisticated products, with appropriate regulatory framework, will help do this. Introduction of sophisticated products with an appropriate regulatory framework will help attract talent and deepen markets. In 2017, we must aim to bring all the volume of the Nifty index from the Singapore market, the offshore rupee non-deliverable forwards (NDFs) from the Singapore and Dubai markets and gold from the Dubai market to Indian shores. London and Singapore show us how big bang reforms in the financial sector creates jobs, capital flows and opportunities.
With the setting up of Gujarat International Finance Tec-City (GIFT city), presence of a regulator like Sebi, and existing talent pool across fund management, operations, sales and compliance in the mutual fund industry, it is possible to achieve the target. Hopefully, 2017 will see concrete actions in that direction.
Nilesh Shah is managing director, Kotak Mahindra Asset Management Co. Ltd.