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  • Dec 20, 2021 - Does the Mutual Fund Industry Have the Ability to Expand Exponentially?

Does the Mutual Fund Industry Have the Ability to Expand Exponentially?

Dec 20, 2021

Does the Mutual Fund Industry Have the Ability to Expand Exponentially?

The mutual fund (MF) space in India is one of the most rapidly growing and competitive parts of the financial sector.

In recent years, growing awareness, financial inclusion, and enhanced access to banking, the industry has seen high engagement from retail investors.

According to a report, individuals with a yearly income of less than Rs 5 lakh account for 30% of assets under management (AUM) in the MF space.

The average AUM of Indian mutual fund industry for the month of November 2021 stood at Rs 38.5 tn.

As per data available with Association of Mutual Funds in India (AMFI), the AUM of the Indian MF industry has grown from Rs 6.8 tn as on 30 November 2011 to Rs 37.3 tn as on 30 November 2021 more than 5-fold increase in a span of 10 years.

That's huge!

Mutual funds have become major vehicle for mobilising savings, especially from the small savers for investment in the capital market.

To help you guide your investment journey in mutual funds, we reached out to Vivek Chaurasia, VP and Head of Research at PersonalFN.

If you're serious about generating money with MFs, you'll want to read this interview...

Equitymaster - There's been a flood of equity IPOs in India. Is the same true in the world of mutual funds too? There's has been news of some innovative New Fund Offers (NFOs) likely to be launched.

Vivek - Yes, the markets are flooded by the initial offerings in stocks as well as the new offerings in the mutual fund space.

In fact, in 2021, mutual fund houses have launched around 180 schemes so far at an average of around 15 schemes per month. Even if we exclude the Fixed Maturity Plans from the list, there were around 133 open ended NFOs this year.

These NFOs have collectively garnered around Rs 760 bn, that too at a time when many of the existing schemes have been struggling to generate alpha over their benchmark. Going by the trend, we see many more NFOs hitting the market in 2022 as well.

In 2018, the market regulator had introduced categorisation norms for mutual funds to prevent duplication of schemes and to ensure that each scheme remains true to its investment mandate.

The categorisation norms restrict mutual funds to have similar schemes in their product basket, but there is no cap on the number of Index Funds, Exchange Traded Funds (ETFs), Fund of Funds (FoFs), Sector/Thematic Funds, as well as close-ended schemes that a mutual fund house can launch.

So mutual fund houses have found the opportunity in these categories to garner more AUM and are trying to be innovative in product launches. They're offering investors more options to choose from.

We have seen launch of several international FoFs, some of these have innovative mandate to invest in another Global Real Estate Securities Fund and Asia Pacific REITs.

Moreover, some new ETFs are mandated to track the offshore index like the Hang Seng Tech index or S&P 500 Top 50.

Recently we even saw a launch of Coinshare Global Blockchain ETF FoF. It gives indirect access to a Blockchain ETF having exposure to global companies participating in the blockchain ecosystem.

Since most of these are passively managed funds, there is no pressure on the fund management team to outperform the peers and the benchmark.

Equitymaster - What's your take on these NFOs? Is there anything on offer which you find interesting and worth a look?

Vivek - I would say that the Indian mutual fund industry is going through a transformation phase in terms of kind of mutual fund products or schemes we have.

Traditionally, mutual funds were designed to invest in stocks across marketcaps or few selected sectors or themes. But now we are seeing new funds that offer investors the benefit of diversification to offshore markets, and that too with innovative concepts.

As a research house, PersonalFN has never been keen on recommending NFOs. In fact, we have a history of rejecting over 90% of the NFOs, as it didn't make much sense to invest in them until they developed some promising track record.

We always tell investors to consider an NFO only if it offers an innovative idea which they may not find in other existing schemes.

Off late there have been quite a few interesting ideas that investors may find attractive, like Motilal Oswal Nasdaq Q50 ETF, DSP Nifty Midcap 150 Quality 50 ETF, Kotak Nifty Alpha 50 ETF, Invesco CoinShares Global Blockchain ETF Fund of Fund, Nippon India Taiwan Equity Fund, Mirae Asset Hang Seng TECH ETF, etc.

Now are they worth a look? It clearly depends on the preference of the investors. One fund may be suitable for investor A but many not match the risk appetite of investor B.

Most of the new funds are either passively managed or thematic offshore funds. Passively managed funds are suitable for cautious investors whose objective is to get returns commensurate to the underlying index. On the other hand, thematic funds are suitable for investors having higher risk appetite.

The fortune of an NFO investing in say REITs will depend on the global real estate markets. Similarly the fortune of the fund tracking the Hang Seng Tech index will depend on the technology company in Hongkong.

While the idea may sound interesting, one should understand their suitability and risk appetite before investing in them. It will be good to set an allocation limit for such thematic funds in one's portfolio, like Thematic and Sector funds should not exceed say 10-15% of ones' portfolio.

Similarly, one can have about 20% to 25% in Passive funds, while the remaining can be in actively managed funds that have a track record of outperforming their benchmark. Once you have set a proper allocation limit, you can look for NFOs with concept that you find interesting.

Give preference to those focused on quality stocks. However, avoid investing in NFOs having exposure to themes or markets that you do not understand.

Equitymaster - There have been quite a few international fund launches. What's your take on these funds? Given these are Fund of Funds, how expensive (or not) is it to own these funds?

Vivek - Recently we have seen series of NFOs that will be investing in international or offshore markets like the US, Hongkong, Taiwan, Asia Pacific, etc. These funds offer investors the option to diversify their portfolio in offshore stocks and benefit from the developments in international markets. These are the markets where Indian investors find difficulty investing in directly.

Hence international funds can be a good option for those investors who actually want to have some allocation to stocks of companies operating in the US or Hongkong or such other countries. You see, with these fund's investors have the option to indirectly hold allocation in international stocks like Google, Facebook, Amazon, Apple, Microsoft, etc.

Investors looking for diversification in offshore stocks may consider investing a small portion of their portfolio in international funds.

Most of the international funds launched recently are positioned in the form of fund of funds. As per the market regulation, for the fund of funds investing in other index fund or ETFs, the maximum total expense ratio (TER) permissible for such scheme is 1% of the daily net assets of the scheme.

Similarly, for fund of funds investing in non-equity schemes (international funds are classified as non-equity) the maximum TER permissible for such scheme is 2% of the daily net assets of the scheme.

These are not very expensive when compared to other actively managed equity funds investors hold in their portfolio. However, before investing, one should refer the scheme information document and check the indicative expense ratio to get a sense of what the fund will be charging.

Moreover, one should also understand the tax implication while investing in international funds, as they do not qualify under equity schemes, and may result in higher long term capital gain tax compared to domestic equity schemes.

Besides, the holding period of less than 3 years is considered as short term, so one will have to hold their investment in international funds for at least 3 years for their gains to qualify as long-term capital gain.

Equitymaster - A question that's often asked is should one go the Exchange Traded Fund (ETF) route, or just invest in a regular index fund. How do you suggest an investor make a choice?

Vivek - Passively managed funds are primarily suitable for investors looking to invest in a particular marketcap index or asset class, without taking the risks associated with the fund manager bias, stock selection, and investment strategies.

There is no selection risk in passively managed funds as the fund manager has no active role in creating the portfolio. They just replicate the underlying index in terms of portfolio holdings and weightages. Hence they're cost efficient and are expected to offer returns in line with the underlying market index. There are no active investment strategies used to generate alpha or outperform the index.

Exchange Traded Funds or ETFs are passively managed funds that are expected to generate returns in line with the index or the benchmark. While ETFs offer liquidity through its listing on the stock exchange, there might be few ETFs that are not that actively traded in the market.

A holder of such ETFs will need a counterparty in the stock exchange in order to be able to sell his units at fair price. In the absence of active buyers, the price of ETFs traded on the stock exchange may be lower than the actual NAV.

So, this can be one big drawback or limitation of holding ETFs and deciding to exit on a real-time basis during trading hours.

On the other hand, index funds too are passively managed and replicate a particular index in terms of portfolio and generate returns in line with the index. The only difference is that they are not traded on the stock exchange.

However, when an investor decides to redeem their units in index fund, they can expect fair value as per the day end NAV.

I think, for investors who have patience should primarily stick to index funds. While those who want to consider mutual funds as stocks and find it adventurous to see the price of their mutual fund units moving up and down and want to transact on a real time basis can consider ETFs.

Yes, if the ETF is offering an innovative investment theme which is not available under index funds, it can be considered by the investors.

Equitymaster - How important is the expense ratio when determining which fund to invest in?

Vivek - The total expense ratio is one of the important factors that impacts the scheme's NAV. It's the cost that is being charged by the fund to the investors. Hence it should be economical for the investors.

The regulation has clearly defined the maximum limit for the expense ratio that can be charged to the scheme in each category. The mutual fund houses cannot charge beyond the specified limit. The market regulator has instructed the asset management companies (AMCs) to disclose the TER for each scheme on a daily basis, on their website and should also be published on the AMFI website.

If two different schemes have similar return potential, the one with a lower expense ratio is expected to give better net returns to the investors. However, there are even few schemes that have a higher expense ratio probably due to their small size, but have managed to generate higher net returns vis-a-vis their large sized peers having relatively lower expense ratio.

While one should have an eye on the expense ratio, it should not be the only deciding factor when choosing a mutual fund scheme.

In fact, expense ratio matters the most in case of the Direct and Regular plan offered by the same scheme. When investing in mutual funds, investors have a choice of executing their transactions through the distributors or else invest directly through the AMCs.

Distributors expect their earning in the form commission for the various services they provide to the investor. Hence each mutual fund has to offer schemes with two plans, viz., regular plan and direct plan. As regular plans carry commission and distribution expenses, they have higher TER.

Whereas direct plans do not pay any commission and hence have much lower expense ratio. Both these plans have difference of around 75bps to 100bps in the TER. Even a difference of 1% in expense ratio can make a huge difference to the funds value in the long run.

Tech savvy and do it yourself (DIY) investors prefer direct route to investing and save a huge amount in the form of expense ratio, which helps them boost their portfolio returns.

Equitymaster - There's a flood of money pouring into equity funds. What are mutual funds doing with all this cash? Is it getting invested...or are some of your tracked funds building cash?

Vivek - The money has been pouring into equity funds since the market lows of March 2020, in the existing schemes as well as through NFOs. In a buoyant market, mutual funds cannot afford to sit on cash. They have been investing in equities.

In the current year 2021, domestic mutual funds have net invested around Rs 616.5 bn in Indian equities as against a net sell of Rs 276.2 bn during the corresponding period in 2020. So, a huge chunk of cash has already found its way into the equity markets.

I haven't seen any significant cash building by any mutual fund I track closely, as most of them have follow an upper limit of 10% for their cash & debt holding. But yes, off-late some fund managers may be holding their cash allocation slightly on the higher side and waiting for an opportunity to invest in if they see any meaningful correction.

Equitymaster - What's your take on debt funds in the context of fear of rising inflation and interest rates?

Vivek - The current interest rate cycle seems to have bottomed out. Most of the rally at the longer end of the yield curve has already come about since the time RBI started reducing policy rates. In other words, debt funds with longer maturity papers may not be able to generate the kind of higher returns they did in the last few years.

Going forward, the returns may moderate on the longer maturity debt papers which could turn riskier as it may encounter high volatility in the foreseeable future. But given the accommodative stance maintained by the Reserve Bank of India (RBI) as long as it is necessary to revive and sustain growth on a durable basis and continue to mitigate the impact of Covid-19 on the economy; there is still some uncertainty as to when policy rates will be hiked.

In such a scenario, investors need to devise a sensible investment strategy even for wealth preservation.

The interest rate risk is inevitable in a scenario when bond yields are facing an upside pressure. But investors can still manage this risk by adjusting their portfolio duration and shifting to funds that focus on accruals, lower duration or have flexibility of investing across maturities depending on the interest rate scenario.

What has been more worrying in the last few years is the kind of credit risk debt fund managers take. Debt fund managers should refrain from taking higher credit risk and focus on high credit quality instruments. But most fund managers do the opposite when they chase high yields.

Investors should understand that debt mutual funds, in general, is not risk-free or safe. In the current scenario, cautious investors, should strictly avoid categories like Long Duration Funds, Medium Duration Funds, Short Duration Funds, Credit Risk Fund, Low Duration Funds, Ultra Short Duration Funds, etc. as they hold predominant exposure to private issuers and expose investors to higher credit risk.

Equitymaster - Post Pandemic, the mutual fund industry faced a crisis of sorts when it came to debt and liquid funds? How has the situation panned out? What's your suggestion to investors who want to park their super sacred funds for short period of time...where should they look?

Vivek - Post pandemic the major trigger point that came in was the Franklin Templeton episode where it decided to shut 6 of its debt schemes overnight. That was an eye opener and a huge shock for investors in these debt mutual funds, who found themselves on the wrong foot and were stuck for months before they could get a portion of their money back.

For years we have been telling investors that even many liquid funds are not safe. Theoretically, liquid funds are supposed to be safe investment option for investors looking to park their absolute short term surplus, while at the same time maintaining safety and high liquidity on their invested principal.

Accordingly, the priority of the fund manager of a liquid fund should be to preserve capital as against maximizing returns. However, many liquid fund managers still try to chase higher yield and take exposure to instruments issued by private issuers which may carry higher credit risk.

Hence, most liquid funds out there try to generate higher yield by exposing investors to credit risk. We believe, liquid Funds should not have exposure to private debt instruments.

While parking your super sacred fund for a short period, you should prefer safety over returns. You should ideally consider cautiously managed liquid funds that resist from taking higher credit risk associated with debt instruments issued by private issuers and instead focus on investing only in Government and Quasi-Government securities.

Equitymaster - What's your message to investors as they try and navigate this period of extreme volatility?

Vivek - Equity as an asset class has always been a promising avenue for wealth creation over the long-term. The historical returns generated by Indian equities in the last several decades are a testimony of the wealth-building potential of equity as an asset class.

Yes, the equity markets are volatile by nature, which cannot be ignored while investing in equities. The markets have recovered sharply from its March 2020 lows, while the margin of safety has declined as compared to what it was last year.

Investors need to be cautious as the valuations have remained stretched and elevated for quite some time, and the equity markets are expected to remain extremely volatile in the near term. However, the dips in equity markets may be considered as a buying opportunity for long term investors having a time horizon of at least 5 years.

Investors need to devise a strategy and take exposure sensibly in high quality stocks or worthy diversified equity funds. One should select the best and the most suitable mutual fund schemes for their portfolio and invest in a staggered manner.

It's suggested to buy gradually through the SIP / STP mode instead of investing all your funds at one go at the market highs.

Also, your investment discipline and asset allocation would play a key role in deciding your success in investing.

Therefore, adopt a sensible approach and follow an asset allocation strategy that is most suitable for you. Your portfolio should remain diversified across asset class with a suitable allocation depending on your risk appetite and time horizon.

Happy Investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...

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