Evolving Business Models in India’s Mutual Fund Industry

The Indian mutual fund industry has been going through turmoil in the last few years due to uncertain market conditions and regulatory changes. Many firms, predominantly foreign ones, have exited the industry since 2008. Existing asset management companies (AMCs) are exploring a number of different models to counter the challenges and stay competitive in the evolving regulatory and competitive environment. The dominant theme that is emerging in the industry is that of formation of partnerships and alliances. This can be gauged from the rising share of private sector joint venture companies that are predominantly Indian in recent times, as discussed earlier. The fusion of global best practices from international partner and local know-how of domestic players is creating good synergy. Some recent examples include partnerships between T Row Price and UTI, Schroders Plc and Axis Bank, Nomura and LIC mutual fund. Realizing the importance of scale in this industry, some firms are taking the inorganic route to grow quickly through acquisition. Along with growth of AuM in a short time, firms try to achieve other strategic objectives as well through this approach. Thus L&T’s acquisition of Fidelity’s business not only increases its asset share, it also increases composition of equity funds in its portfolio, and thereby raising the potential for fee-based revenues. Similarly Goldman Sachs acquisition of Benchmark, the earliest and leading provider of Exchange Traded Funds (ETFs) in India, allowed the firms to gain foothold into the fast growing ETF segment. Some bank sponsored mutual funds are trying to focus on distribution through parent bank branches. Though they are not opposed to third party distributors selling their products, they are not actively exploring that channel. Some international asset managers have exhibited interest to tie up with such banks to garner market share in this way. Partnership between Union Bank and KBC Asset Management is one such example. While typically 50-60% of equity funds are sold through parent branch network in case of bank sponsored mutual funds, the aim of such initiative is to sell 80-90% of the funds through parent bank’s network. However, the foreign partner needs to be careful regarding its choice of bank partners, as we have seen having large branch network does not guarantee easier access to more assets. Mutual fund business clearly has to be a strategic focus for the partner bank. Bankers in general are not very aggressive about mutual fund business, as most of their time and resources are spent on helping banking clients with normal banking services. Margins from banking services are higher than mutual funds in many cases, and therefore sales of mutual funds are often not given adequate focus. Instead of forming strategic alliances, in some cases fund houses have tie ups with banks just to distribute their products. For example, Birla Sun Life, HDFC, IDBI have such agreement with Syndicate Bank. However, this approach has achieved limited success so far. Moreover, if the bank itself is a sponsor of mutual funds, there is clearly conflict of interest, which fund managers need to keep in mind. Observing the increasing shift from transaction based to advice based model of the fund business, some firms have initiated or strengthened their portfolio management services. This is primarily targeted towards the higher end of the mass affluent segment and the HNI segment, as they are usually big ticket investors, have needs to manage a broad portfolio, and are more likely to pay fee for advice. It should be mentioned that India does not have a well-defined wealth management industry, and this initiative has a lot of overlap with the provision of wealth management services. HNI segment traditionally has turned to the international banks in the country for wealth management services which helped them with offshore investment opportunities and international best practices. However, the domestic asset managers are increasingly moving up the value chain and making inroads in the wealth management space. It needs to be said even though a number of AMCs has started offering this service, only a few of them (e.g., Kotak, ICICI) have been successful. Some Indian AMCs are now taking the next step of garnering investments from international investors by opening offices in international locations like New York, London, Singapore, Japan and the Gulf countries. Earlier they would pay high commission to foreign distributors in local markets to sell their products; now they are trying to be in charge of distribution themselves by opening offices in those locations. This way they save on paying commission, and also benefit from high margin of managing international investors’ money. While the ambition is to cater to the entire gamut of international investors, NRIs are more likely to provide early in-roads for success. Here again, some firms are looking at prospects of strategic partnership with foreign fund houses to gain quicker traction in foreign markets. Examples include UTI’s plans of launching offshore Shariah funds in the Gulf region. Some of the other leading AMCs are also planning to go international. Improving operational efficiency is an area that has not received much attention, but can be a cost saver. Indian financial firms have traditionally lagged in the adoption of technology and processes that increase efficiency of operations. However, this situation has somewhat improved in recent times with the banks and brokerages increasing their use of technology. For banks the driver has been regulations, while competition from foreign brokerages has forced domestic brokerages to adopt latest technology. Unfortunately there is no such driver for the AMCs. Firms need to give this aspect more consideration than they have given in the past.

Trends in Indian Mutual Funds since Abolition of Entry Load

The Securities and Exchange Board of India (SEBI) has undertaken a number of initiatives and brought in new regulations for the mutual fund industry in the last two years, the most important change being the abolition of entry load for selling mutual fund products since August 2009. The effect of this rule change has been widely debated. Some argue the impact of this change has not been significant as fund flows have registered year on year growth in 2009, while others argue that in absence of upfront commission distributors are now less motivated to sell mutual funds. We take a look at quarterly sales data of equity mutual funds to analyze the effect. Sales of euity funds, which constitute a third of industry AuM, is a good proxy to understand retail investor buying behavior, because the retail (including HNI) segment accounts for around 85% of total equity fund assets. According to data from AMFI, quarterly sales have been steady since the second quarter of 2009, and higher than they were in 2008. However, one needs to decouple the effects of the crisis that hit the markets in 2008. From the figure, one can conclude that though equity fund sales grew after the rule change, they are still far below the trends observed during 2006–2007. The decline in 2008 was due to market conditions, but subsequent recovery has not been commensurate with overall market improvement. Equity fund sales moved in tandem with SENSEX in the pre-2008 period, but post-2008 the gap has widened. Two points are worth considering here. The crisis of 2008 may have made investors more risk averse. While they were buying heavily during the bull run of 2006-07, post-crisis they have become apprehensive of investing in mutual funds. Another reason for lack of investor participation can be the lower returns generated by the fund managers. A recent study by Standard & Poor’s and CRISIL showed that a majority of actively managed mutual fund schemes in India have underperformed their respective benchmarks over the five-year period ended December 31, 2010. This may have made retail investors shy further away from investing in mutual funds. In summary, it can be said that the recovery of the Indian mutual fund industry since the crisis of 2008 has not been commensurate with the overall market recovery. The abolition of entry load has had an impact on sales from the retail segment, but it is not the only reason. Failure to outperform benchmark indices is another equally important issue afflicting the industry.

Quarterly Equity Mutual Fund Sales

<!–[if !mso]> <! st1:*{behavior:url(#ieooui) } –>

The Securities and Exchange Board of India (SEBI) has undertaken a number of initiatives and brought in new regulations for the mutual fund industry in the last two years, the most important change being the abolition of entry load for selling mutual fund products since August 2009. The effect of this rule change has been widely debated. Some argue the impact of this change has not been significant as fund flows have registered year on year growth in 2009, while others argue that in absence of upfront commission distributors are now less motivated to sell mutual funds. We take a look at quarterly sales data of equity mutual funds to analyze the effect. Sales of euity funds, which constitute a third of industry AuM, is a good proxy to understand retail investor buying behavior, because the retail (including HNI) segment accounts for around 85% of total equity fund assets.

According to data from AMFI, quarterly sales have been steady since the second quarter of 2009, and higher than they were in 2008. However, one needs to decouple the effects of the crisis that hit the markets in 2008. From the figure, one can conclude that though equity fund sales grew after the rule change, they are still far below the trends observed during 2006–2007. The decline in 2008 was due to market conditions, but subsequent recovery has not been commensurate with overall market improvement. Equity fund sales moved in tandem with SENSEX in the pre-2008 period, but post-2008 the gap has widened.

Two points are worth considering here. The crisis of 2008 may have made investors more risk averse. While they were buying heavily during the bull run of 2006-07, post-crisis they have become apprehensive of investing in mutual funds. Another reason for lack of investor participation can be the lower returns generated by the fund managers. A recent study by Standard & Poor’s and CRISIL showed that a majority of actively managed mutual fund schemes in India have underperformed their respective benchmarks over the five-year period ended December 31, 2010. This may have made retail investors shy further away from investing in mutual funds.

In summary, it can be said that the recovery of the Indian mutual fund industry since the crisis of 2008 has not been commensurate with the overall market recovery. The abolition of entry load has had an impact on sales from the retail segment, but it is not the only reason. Failure to outperform benchmark indices is another equally important issue afflicting the industry.

Electronic and cross-border trading in Asia

I recently participated as a moderator in two panel discussions on the South East Asian markets in the SunGard City Day held in Singapore on 14th July, the topics being electronic trading and cross-border trading respectively. An important point that came out of the discussions was that Asia-Pacific cannot be seen as one market, unlike the European Union. It comprises of various national markets at different stages of development. Japan, Australia, Singapore and Hong Kong are the leading markets in the region. By comparison, markets such as Indonesia, Malaysia and China are lagging behind. The difference can be seen in terms of infrastructure, e.g., the differences in the latency of the exchanges, as well as the number of products that can be traded on them. In the leading markets, the circumstances are becoming more conducive to high-frequency trading and the operation of alternative trading systems, including dark pools. Co-location services are being provided by the exchanges and the regulators are reducing the barriers on off-exchange transactions, such as the limits on the size of transactions and the time limit within which a transaction has to be reported. A crucial factor in the adoption of greater electronic and algorithmic trading will be the willingness of the buy-side to develop the infrastructure for the same. An interesting example that was quoted in the event was that a buy-side trading desk took three months just to fine-tune the latency of their connectivity to the exchange. What this highlights is the fact that while many in the local sell-side and increasingly the buy-side are convinced of the need to have algorithmic trading, it will take time to put the necessary systems in place. Also, the local players are not sure about whether they can afford the level of investment (and the time taken) required to create the trading infrastructure. Hence, the barriers to adoption of technology are more practical than theoretical, unlike earlier. In fact, most of the panelists stressed that there has been a sea-change in the mindset of the domestic market participants in the last 2-3 years and they are much more open to having algorithmic trading and dark pools now. It is further expected that once ADR/GDRs can be traded in these exchanges, the level of algorithmic trading will go up, with the greater presence of exchange-traded funds also playing a similar role. However, the level of off-exchange trading in the next 3-4 years is expected to go up to 5% at the most, up from the current 1% but much below the 30% levels seen in Europe. Cross-border trading in the ASEAN region has picked up in the last few years. Regulation has also paved the way for this, e.g., in Malaysia, regulation has recently allowed up to 30% of the NAV of a firm to be used in trading assets abroad. Even before the recent ASEAN linkage between six countries was announced, cross-border trading was a prevalent phenomenon. The linkage is expected to increase the level of electronic trading and also make it cheaper and more efficient. The next step should be to develop the post-trading infrastructure and linkages between the central securities depositories.