February 7, 2008

Make MF schemes investor-friendly

By Dr C Rangarajan

It gives me a great pleasure to be present at this award function of ICRA to recognize the service that individual mutual funds have made to unit holders. Let me at the outset congratulate all those who are receiving awards this evening.
The best way to promote excellence is to honour people and institutions of excellence. While the origins of the Mutual Fund (MF) industry can be traced back to the nineteenth century, its scale and popularity increased from the second half of the last century. Indeed, much of the expansion of the MF industry has occurred in recent years with total funds under management having risen fivefold over the last seven years.
MFs play a significant role in intermediating small savings for growth and investment. They give individual investors the advantage of diversification that is of investing in a wide range of diversified and liquid products of varying yield, maturity and risk. They also cater to every profile and risk taking capacity. They minimize risk and maximize returns with low transaction costs through bundling of products and professional management.
Considering the advantages of investment in MFs over bank deposits it is not surprising that assets managed by MFs in the US have exceeded bank assets ever since the mid 1990's and are currently equivalent to about 90% of the GDP. MFs in India are constituted in the form of public trusts created under the Indian Trust Act, 1882.
According to the SEBI (Mutual Funds) Regulations, 1996, a MF is "a fund established in the form of a trust to raise money through the sales of units to the public or a selection of the public under one or more schemes for investing in securities, including money market instruments".
India's MF industry was founded in the 1960's when the first MF was set up under the UTI Act of 1963, and the Unit Scheme 64 launched in 1964. The assets of the Indian MF industry increased from Rs. 49 Crore in 1964 to over Rs 5,000 crore in 1987. UTI's monopoly in the Indian MF industry ended in 1987 with the entry of public sector banks and insurance companies. Public sector monopoly in turn ended with the entry of private players in 1993.
At the end of 1993, the MF industry had Rs 47,004 crore of assets under management (AUM). There was subsequently an explosive growth of the mutual fund industry in the country with the total AUM climbing rapidly to Rs 328,745 crore as on March 31, 2007 and to about Rs 5,50,000 crore by December 2007.
Private sector mutual funds currently manage over 80% of the total assets of the mutual fund industry. The Indian mutual fund industry has a healthy mix of purely foreign owned entities, joint ventures with predominantly foreign ownership, purely Indian owned and joint ventures with predominant Indian ownership. This is indeed a welcome development, extending to the industry a richer and wider array of perspectives, planning horizons, motivation and priorities.
In sharp contradistinction to the situation prevailing in developed financial markets such as the United States, where mutual fund assets exceed those of the banking sector, their assets in India constituted just 13% of bank deposits as of March 2007.
This ratio has no doubt risen significantly to 18% in December 2007, but this is mostly due to an unprecedented stock market boom, as a result of which the share of equity based growth funds in the AUM has risen from less than 10% five years ago to over a third at the end of 2007.
Despite this growth, the greater proportion of financial savings continues to reside mostly in the banking sector or is deployed directly by investors in stock markets. Also, while individuals own about 90% of mutual fund assets in the United States, they hold just over 40% in India, even though they comprise over 95% of unit accounts. This is an anomalous situation since mutual funds are supposed to cater primarily to small domestic investors rather than to Institutions, Corporates and High Net worth Individuals.
The limited reach of mutual funds in rural areas is another cause for concern. Indeed, most of the fund houses have their sales office locations in the top 10 cities, with a token presence in the remaining cities. According to the Invest India Economic Foundation survey, there are around 34 million persons with the potential and capacity to invest in mutual funds. Some 57% of such persons live in rural areas.
There is therefore great scope for both widening and deepening the spread of the mutual fund industry in India through greater penetration of rural and lower income groups in non-metropolitan areas. This financial inclusion of investors from other areas can be achieved through investor education, awareness building, networking and greater use of information technology.
Continuous regulatory reform and oversight by SEBI has no doubt been instrumental in making mutual funds more transparent, investor friendly, cheaper and popular over the last few years. SEBI has moved to gradually reduce the number of fees charged by Mutual Fund Managers, the most recent move being a few days ago when the initial issue fee for close-ended schemes was done away with.
SEBI's move to waive entry load for applications received directly by the AMC (ie. not routed through any distributor or agent or broker) is another welcome reform. The process of regulatory reform needs to continue to make the fee structure and distribution network more transparent and small investor friendly. Steps need to be taken to counter perverse incentives that encourage funds to churn portfolios excessively.
A robust expansion of the Mutual Fund industry is critical on account of the major role they are expected to play in garnering the huge resources required to quickly develop India's infrastructure that is currently the single biggest long-term constraint on sustaining high growth rates of 9-10%.
Various government bodies & Committees, international agencies and research houses estimate the investment requirement for the infrastructure sector during the next five years to be in the range of US $300-450 billion.
In the 2007 budget speech for the fnancial yar 2007-08, the Finance Minister drew pointed attention to the need to promote the flow of investment to the Infrastructure sector by permitting domestic mutual funds to launch and operate dedicated Infrastructure funds
Mutual funds also have a critical role to play in increasingly ageing societies. Not only are people living longer after retirement, but pension systems the world over, including India, are being overhauled by moving from fiscally damaging tax payer funded pay as you go systems to defined contribution pension systems where both employer and employer contributions are invested. Individuals are therefore required to plan their own financial and retirement savings. Mutual funds have a major role to play in this process of reform of pension systems, as they offer a range of products catering to different age and risk taking profiles.
I would like to draw your attention to some practices prevalent in the Mutual Fund industry that remain to be addressed. Information is a major concern. Take the case of advertisements for mutual funds that are expected to carry statutory warnings regarding risks. The rapid-fire manner in which the warning is read ensures that the warning is effectively suppressed. Or take the indigestible information overload caused by multiplicity of products. While consumer choice and competition is a good thing, there has been such a proliferation of products that the retail investor can be quite bewildered. We have thus income funds, balanced funds, liquid funds, Gilt funds, index funds, insurance linked funds, sectoral funds, assured return funds, close-ended funds and open-ended funds.
There is a fund for every body with every conceivable need! The number of schemes at the end of August 2007 was 768, equal to the number of securities listed on NSE. To complicate things further, a scheme may have sub-schemes with different plans and options. As a result it is those funds that are aggressively distributed that carry the day.
While diversification and expansion of choice that caters to different profiles are on balance a good thing, much more can be done to educate investors in making informed decisions best suited to their own profiles.
That brings me to the issue of distributors, who are critical players in the industry because Asset Management Companies do not operate through retail branches like the banking and insurance industries.
On account of poor financial literacy and information asymmetries, most retail investors do not have the expertise to make the right investment decisions, and frequently turn to distributors for advice on such decision-making. Most distributors consequently double up as financial planners and sellers of MF products, leading to a clash of interest. Some distributors are known to push schemes, such as New Fund Offers (NFOs), that earn them much higher commissions than existing schemes. The distribution fee can be as high as 60% of the management fee on some products.
Both SEBI and AMFI need to do more to address the distributor problem if the MF industry is to take significant strides forward. The extent of independence of trustees from the sponsor has also been a matter of debate. Two thirds of trustees are required to be independent under the law. The law attaches a significant role for the trustees, and it is the trust reposed in the Trustees that drives investors to a particular fund.
Effective independence is critical to impart credibility. The Indian Mutual Fund industry has come a long way from its UTI origin and its future looks bright. The challenge before such funds is to bring in more retail investors especially those in small towns and rural areas into the fold of mutual fund investment. There is a need for more investor education and generation of awareness with regard to both risks and rewards.
There is also a need to check unhealthy market practices. I am confident that the industry would rise to the occasion and help to sustain the high growth of 9 per cent and above which is very much in the grasp of the Indian economy. This would also enable individual investors including those in rural India to share in this rising tide of prosperity.

This is  the address of Dr C Rangarajan, chairman, Economic Advisory Council to the Prime Minister at the fifth  annual ICRA Mutual Fund Awards function in Mumbai on February 5, 2008