AI 15: India’s funds potential depends on pensions

Lack of regulation and poor investor awareness are holding back the growth of Indian mutual funds, despite decades of strong growth.

The funds business has seen exits and consolidation in recent years, partly because of business models used and levels of commitment to the market.

But firms with a sustainable business model face a promising future thanks to a reviving economy, regulatory and policy changes, and looming fundamental shifts in the industry.

While India’s funds industry can be traced to 1964 when the Unit Trust of India was set up, its real start was three decades later when global players and Indian private bank-sponsored asset management companies began operations.

The industry has since developed world-class capital market infrastructure, a robust regulatory regime and an open architecture based on multi-channel distribution.

Assets under management grew from less than Rs500 billion in 1993 to more than Rs11 trillion ($176 billion) in 2014. This compound average growth rate (CAGR) of 16.2% was achieved despite the 2008 crisis and the ban on entry loads in 2009.

Nonetheless, mutual fund penetration is low: the ratio of AUM to GDP is 7-8%, versus the global average of 37%, according to a recent PricewaterhouseCoopers report.

Several things hold mutual funds back in India. One of them is regulation: managers are not actually allowed to address the assets of insurance companies or pension providers.

A bigger challenge is the low level of investor awareness. The majority of people prefer to invest in physical assets such as real estate and gold, which are perceived (wrongly) as low risk.

While such attitudes are not new, the global financial crisis convinced many investors to retreat from the stock market. They have yet to return, despite the stellar returns that equity funds have provided. The Crisil-Amfi Equity Fund Performance Index, which tracks the performance of India’s equity mutual funds, has delivered annualised returns of 44% over one year, 14% over five years and 18% over 10 years.

Active managers have, therefore, consistently outperformed the stock market, given that the S&P BSE Sensex has generated CAGR of only 24%, 10% and 16% over the same time periods.

As a result of industry weaknesses, the funds business has seen exits and consolidation, although this is usually due to choice of business model and ability to commit to the market rather than any lack of growth or profitability.

Those firms with a sustainable business model, however, face a promising future. The economy is beginning to revive thanks to regulatory and policy changes, and the funds industry now stands at the cusp of some fundamental shifts.

These include the possibility of opening voluntary pensions to the funds industry, new fee models, growing institutional business by managing money for offshore funds, mainstreaming alternatives, and developing technology such as mobile for advice and execution.

The government’s 2015 budget is supportive of these changes. It has increased tax deductions from contributions to a pension fund and the New Pension Scheme, which should help to boost retirement savings. With additional support from regulators, fund management companies will be able to launch pension products.

This is critical because globally, retirement products have been the growth driver for asset management. In the US, more than 38% of industry assets, about $6.5 trillion, comes from contributions to individual retirement accounts and company defined-benefit plans. The introduction of America’s 401K tax arrangement in the 1970s was a gamechanger for building awareness of mutual funds, and helped the industry to achieve massive scale. Today, 50% of US households own mutual funds, versus less than 4% of Indian households.

Industry executives are optimistic that regulations will also enable the introduction of real estate investment trusts. Real estate investment trusts (Reits) are popular globally because they offer periodic cash flows, and plenty of Indian investors would like to enjoy a regular income.

Another product that should become more popular in India is exchange-traded funds, which exist onshore but have yet to receive the kind of giant inflows that ETFs have gotten elsewhere.

ETFs can become popular here too, over time, especially once institutional investors increase their participation. The government has begun to use ETFs to divest itself from stakes in public-sector enterprises, and it’s easy to envision more such products coming to market. Together, ETFs and Reits would represent the mainstreaming of alternatives.

The government is taking further steps to enhance India’s funds industry, such as encouraging talented industry professionals to relocate to India, and supporting local asset managers’ bid to run money on behalf of foreign, India- dedicated portfolios.

This gives Indian fund houses an opportunity to seek managed-account mandates from international players. The Securities and Exchange Board of India, the securities regulator, is also determined to improve standards of governance, to engender greater confidence among investors.

Ashu Suyash is CEO of L&T Investment Management