Overview: Mutual Fund sector

The mutual funds (MF) have emerged as one of the important investment vehicles that cater to the saving needs of retail investors. Mutual funds pool savings of households and other investors and invest in different instruments like shares, bonds, debentures, and other securities.

Evolution of Mutual Fund Industry in India

The mutual fund industry emerged much later in India as compared to the developed countries like the US and Europe. The foundation stone of the industry was laid in India in 1963 when the Indian government and the RBI formed the Unit Trust of India (UTI). Earlier UTI was controlled and administered by the RBI, but in 1978 the entire mutual fund industry came under the regulation and control of the Industrial Bank of India. In 1987, the industry witnessed the entry of public sector mutual funds and by the end of 1993 it had Rs 470 bn worth of assets under management (AUM). In 1993, which is a landmark year for the sector, the first mutual fund regulation was enacted and players from the private sector were allowed to enter the industry. In 2003, after the fall out of the US 64 schemes, the Unit Trust of India Act 1963 was abolished and accordingly, the assets of UTI were de merged into two entities namely UTI and UTI Mutual Fund. Evidently, the UTI was not under the purview of the mutual fund regulations unlike the UTI Mutual Fund. Since 2003, several mergers took place among AMCs, which led the mutual fund industry into a new phase of consolidation and growth.

Major policy initiatives and development in the MF industry

The Securities Exchange Board of India (SEBI) issues guidelines from time to time to protect investor interest and to ensure proper regulation of the mutual industry. Some such initiatives taken by SEBI in recent times have been listed below:

1. In June 2009, SEBI announced the removal of the entry load for mutual fund investors with effect from August 1, 2009. However, systematic investment plans (SIPs) were excluded from this benefit. Accordingly, investors in SIPs will continue to pay 2.25% entry load per month. Earlier, from Jan 2008, SEBI had removed the entry load on direct applications.
2. MFs have been allowed to park funds, pending deployment, in short-term deposits of SCBs.
3. The aggregate industry-wise ceiling for overseas investments by mutual funds was raised to US$ 4 bn and subsequently to US$ 5 bn. Also, within the overall limit, mutual funds have been allowed to make overseas investments subject to a maximum ceiling of US$ 300 mn per mutual fund.
4. The limit on investment and advisory fee for index fund schemes has been reduced to 0.75% and the total expenses of the scheme including the investment and advisory fees have been lowered to 1.5% of the weekly average net assets. These reductions have been made applicable to exchange traded index funds also.
5. Mutual funds have been allowed to engage in short selling of securities as well as in lending and borrowing securities.
6. In order to bring in more transparency and clarity to investors in terms of expenses charged in close-ended schemes, SEBI has decided to do away with the provision of charging initial issue expenses and amortisation of the same. All mutual funds were thus required to meet the expenses related with sales and distribution of schemes from the entry load.
7. MFs dedicated to the infrastructure sector were released to ensure more fund availability for the sector.

These policy initiatives provide transparency in the system and help investors to make informed investment decisions.

Trends in the mutual funds industry
Industry sees high growth on the back a booming economy

The mutual fund industry witnessed stupendous growth during FY04-FY08. During this period, the economy grew at an average rate of over 8.8% and most industries rode on this growth wave and clocked a healthy rate of growth. During this period the stock markets also had a good run, which pushed up investor confidence.

Companies posted impressive performances due to high economic growth fuelled by more consumption in domestic and international markets. Consequently the per capita income grew at a CAGR of 17.0% to Rs 29,786 during the said period. Rising income levels helped to raise total household savings, which increased in different asset classes. During FY08, the household sector contributed around 65% to the total gross domestic savings. With the rise in income, the households increasingly parked their savings in financial assets. In FY08, the savings in financial assets grew by around 30% at Rs 7,347 bn over FY06.

Household investments in mutual funds increase

The household sector increased its exposure in the MF segment during FY06-FY08 due to the attractive returns offered by the MF schemes owing to the upsurge in stock markets, and due to its growing income levels. Over the past few years the household savings in the MF industry witnessed splendid growth, much above the savings growth in banking and insurance industries. The household sector’s savings in the MF industry increased from Rs 226 bn in FY06 to Rs 568 bn in FY08.

The positive sentiments aroused by the buoyant growth in the economy and the industry were noticed in the stock markets also. The BSE Sensex rose rapidly after witnessing moderate growth till 2004-05, and attracted huge amount of surplus from the international and domestic investors. This euphoria provided an impetus to the returns on investments made by the MF industry and at the same time it also increased the industry’s total gross mobilisations, which grew by over 300% to Rs 44,643.8 bn in FY08 over FY06.

Surge in stock markets props up investments in MFs

Buoyant stock markets attracted individual and institutional investors alike. The surge in investor interest in mutual funds was evident from the growth trend in AUMs. Normally the movement in AUM is related to the movement on the stock markets, and gives an indication of the rising investments. The stupendous economic growth, the resultant increase in per capita income, and the flow of money from international investors changed the mutual fund industry’s fortunes. Since FY05, the AUMs have been growing consistently and have recorded an average growth of more than 600% during FY04-08. However, the dip in AUM in FY09 was a repercussion to the slowdown in the economy and the dip in stock markets that made investors cautious.

Growth/equity-oriented schemes gain market share in MF scheme categories

Until FY05 the total net inflows in the MF industry had been very uneven. After that, the industry stabilised and garnered a whopping total net inflow of around Rs 1,538 bn, which grew by over 190% over FY06. Earlier income/debt-oriented schemes had a major share in the net inflows of the MF industry; during FY02-FY04, these schemes formed over 80% of the total net inflow. However, in the recent years, this trend of investments has been changing. Due to the strong performance in the equity markets, there was a shift in investments towards the equity/growth-oriented schemes in FY04. The net inflow into these schemes has increased considerably since then, and so has its contribution to the total net inflow of the industry. Since FY04, the contribution of equity/growth-oriented schemes to the total net inflow has been around 36% on an average. On the other hand, the contribution of the income/debtoriented schemes has been falling from 80-90% (prior to FY04) to around 60-65%.

Besides the equity/growth-oriented schemes, even the pattern of inflows into the balanced schemes has been improving. Prior to FY04, the growth in these schemes was suppressed by the negative inflow into the industry; however, since FY05, investors have realised the importance of these schemes and have started parking their funds in balanced schemes as well. As these schemes were established to lower risk of volatile stock markets and to provide relatively secured returns, its contribution to the total net inflows increased to 3.75% in FY08 from 1.76% in FY06.

Mutual fund releases surplus cash to equity markets as Sensex rises

The figure below illustrates the trend in equity gross purchases by mutual funds with respect to the movements on BSE Sensex. In the first quarter of 2008, the equity gross purchases continued in spite of a fall in the BSE Sensex, because of the high returns of the schemes and buoyancy in the industry. In the second and third quarters, the global economy slid into recession as the global banks and equity markets collapsed, and the equity gross purchases fell by around 40% in August 2008. The equity purchases have been declining ever since. In the fourth quarter the stagnation in the stock markets discouraged equity purchases.

The MF industry witnessed a 15-month low in February 2009 as equity purchases were worth only Rs 60.6 bn. However, the stagnation in equity purchases could be attributed to the industry’s unwillingness to part with cash due to apprehensions over the sliding global markets and the global economic meltdown. In the first quarter of 2009 the global economy saw some signs of revival and this reflected well at the bourses. In April 2009, the MF industry released surplus cash to the equity markets and in June 2009 the equity purchases grew by 50% over the previous year and touched a 15-month-high.

Mutual funds investments surpass FII investments

During FY04-FY05 the foreign institutional investors’ (FIIs) investments in equity and debt instruments were more than that of MFs. However in FY05, the net investments made by MFs surpassed the net investments by FIIs; since then, the MF industry’s investments in these instruments have been more than that of FIIs. The net investments of the MFs during FY04-FY08 outperformed that of FIIs and grew at a CAGR of over 400% as compared with the more than 270% CAGR in FIIs’ net investments.

The composition of investments of MFs and FIIs tend to be different. While MFs are more exposed to debt, the FII investments lean towards equity. On an average, debt forms around 85% of MF’s total net investments and equity forms around 89% of FIIs’ total net investments. Notably, while MFs’ investments in debt instruments have been increasing consistently since FY06, the investments of FIIs in the equity markets have been wavering.

Global financial crisis takes sheen out of FII investment during 2008

The investment by FIIs in stock markets started drying up as the global financial crisis spread. The liquidity crunch and falling stock markets globally led institutions to re-shuffle their portfolios across the world. In order to meet financial and portfolio requirements FIIs turned into net sellers in Indian stock and debt markets.

During FY09 FIIs withdrew significant amount of funds from the markets owing to fears of meltdown in the global economy, the prevailing credit crunch and the dwindling stock markets; as a result, investments in the equity segment saw a tremendous fall in FY09, and traversed into negative territory. Even though the total net investments of MFs declined over FY08, the MF industry managed to provide positive inflow into the equity and debt markets in FY09. The falling indices affected the MF inflows in the equity segment but it also boosted investments in the debt segment, which grew by around 10% y-o-y in FY09 largely aided by the unstable equity market and the fall in interest rates. Further, debt markets also attracted positive net inflows because they provide relatively secured returns as compared with the equity markets.

Mutual funds’ equity investments compensate for FII withdrawals

Due to the liquidity crunch during 2008 and early 2009 FIIs dumped the Indian stocks and stocks in other emerging markets. Domestic mutual funds, on the other hand, were buying stocks to avoid mayhem in the markets. The net sales by FIIs in stocks bottomed out in October 2008, when the FIIs were net sellers of equity worth Rs 153.47 bn. This scenario immediately followed the bankruptcy of Lehman Brothers in September 2008, and resultant liquidity crunch in global markets. During this period, the domestic mutual funds were net buyers to the tune of Rs 14.31 bn. The chart below represents the net MF and FII investments on Indian stock exchanges.

During the 15-month period between April 2008 and June 2009, the FIIs were net sellers of equity for 9 months. MFs, on the other hand, were net sellers only for 5 months, and their investments were less volatile. Also during the entire 15-month period, the FIIs were net sellers for equity worth Rs 172.5 bn while MFs were net buyers to the tune of Rs 101.5 bn. The outflow of money by FIIs was marked by huge variations in the quantum of amount withdrawn. Although MFs also saw some redemption during this period, the net investments were less volatile. However, the scenario started improving in the stock markets since March 2009 and till July 2009 it experienced some bullishness. FIIs started buying again and their net buys during April-June 2009 were worth Rs 304.5 bn.

Income/debt-oriented schemes withstand crisis as compared to equity and balanced schemes

As the global equity markets tumbled during the second half of FY09, investors turned towards debt markets in search of stable returns. The entire FY09 was a turbulent year for the mutual fund industry. Most economies around the world witnessed stagnant growth during this year and there was a consequent downfall in the global stock markets. As investors shied away from the market there was a fall in the MF industry’s gross mobilisations. The waning stock markets and diminishing value of investments forbade the MF industry from providing attractive returns to investors.

The total AUM growth entered a negative territory in the second and third quarters of FY09 after recording miniscule growth of around 3% in the first quarter of FY09. As a result the value of assets under income/debt-oriented and equity/growth-oriented schemes fell considerably. However, the fall in the equity/growth-oriented schemes was much steeper than the other schemes. In FY09, the equity/growth-oriented schemes posted negative growth of around 37.0% in their AUM whereas the value of assets under income/debt-oriented scheme fell merely by 6.0% over the previous year. In the last quarter of FY09, however, the industry stabilised as the AUM under income/debt oriented schemes posted growth of around 3% and AUM of equity/growth-oriented schemes fell by just 2%. As early signs of a global economic recovery were seen in the first quarter of FY10, the AUM posted a healthy growth of around 40%. Consequently the value of assets under both income/debt and equity/growth-oriented schemes surged by over 36% and 48%, respectively.

Though it’s still uncertain when the industry will return to its most-impressive phase, certain events have been reassuring. For instance, in recent times, many fund houses have come up with new fund offers. Interestingly, even sector-specific schemes have made a comeback. However, in the short-term, the MF industry is not likely to recover from the falling equity or debt markets. Further the new entry load guidelines by SEBI may prove to be deterrent. Wide distribution of MF products may get affected by the problem of commission to distributors.