Indian funds should focus on reducing expense ratios: Kunal Kapoor

Interview with CEO, Morningstar Inc

As Indian mutual fund assets grow, there will be a fall in the proportion of funds beating their benchmarks, says Kunal Kapoor, CEO, Morningstar Inc. In an interview with Ashley Coutinho, he says the industry could probably see a shift to solution-based offerings such as lifecycle funds over time.

Edited excerpts: 

Indian mutual funds have seen sizeable inflows this year, buoyed by systematic investment plans of over Rs 5,000 crore every month. The total size of the industry now stands at over Rs 21 lakh cro with equity assets of over Rs 7 trillion. What changes do you foresee for the industry as it grows in size – for manufacturers, distributors and investors? 

With increasing competition and scale, manufacturers should be able to focus more on lower cost products such as ETFs. The industry could probably see a shift to solution-based offerings over time, akin to developed markets such as the US where offerings such as target date funds or lifecycle funds are fairly common. 

For the distribution industry two to three major changes could be expected. One is a shift from commission to fee-based remuneration. Developed markets such as the UK have made this shift and, in the US, we’ve recently seen the introduction of the Department of Labour regulations with a focus on advisors’ fiduciary responsibility towards investors. In India, this shift would need to be balanced with the need to increase the penetration of mutual funds among retail investors. 

As the complexity of investor needs, investment options and regulatory compliance increases we could start to see advisors outsource investment activities such as asset allocation and portfolio construction to third-party experts. 

Unlike developed markets, active investing still dominates in India. ETFs and index funds are still a niche area, with the former hampered by low liquidity and lacklustre participation from retail, or individual, investors. It’s only recently that these passive products have seen significant inflows thanks to money allocated by the country’s pension money manager Employees’ Provident Fund Organisation. How long before the scales tip to passive investing in India? What will be the key factors driving this? 

Across the world, the dominant narrative is that it’s hard for active managers to outperform their indexes. But in India the majority of the active managers still beat their benchmarks. 

We conducted a study recently to determine the drivers of this outperformance. The results suggest that the outperformance is largely driven by superior stock selection rather than systemic factors such as market risk premium, size premium, value premium and momentum. This is more prominent in the small/mid-cap fund universe where fund managers have a wider pool of companies to choose from with little or no analyst coverage. 

Equity mutual fund assets in India still account for about 5.5 per cent of the overall equity market capitalization. In developed markets like the US, this number is in excess of 30 per cent, which makes it harder for the average manager to outperform the benchmark. As Indian mutual fund assets grow, there will be a fall in the proportion of funds beating their benchmarks.  

The funds rating industry in the US has come under criticism for failing to guide investors to the right funds or schemes. While the ratings have been able to point out star performers of the past they are not a reliable guide to pin-point schemes that will do well in the future. How are you addressing these concerns? Could you highlight a few measures being employed to make the ratings system more transparent and relevant to investors, especially individual investors?
We have often acknowledged the limitations of measures that are based on past performance, like the Morningstar Rating for Funds, better known as the “star rating”. This is why we’ve consistently described the star rating as a potential starting point for research and cautioned investors not to rely exclusively upon it when choosing funds. All the same, we believe the star rating can usefully tilt the odds in investors’ favour. For example, star rating points investors toward cheaper funds that are easier to own and likelier to outperform in the future. 

We have also been developing tools and analytics that can be used in combination with the star rating. For example, we introduced the forward-looking Analyst Rating for funds in 2011. What’s more, we frequently assess the performance and relevance of data points, including our ratings, and transparently share that analysis with investors. 

In 2016, we analysed the performance of the Star Rating globally and, this month, we did the same for the Morningstar Analyst Rating. The star rating study found evidence that it was moderately predictive, while our research on the Analyst Rating found that, on balance, it has succeeded into predicting funds’ future risk-adjusted performance. 

The Indian capital market regulator recently introduced norms for categorisation of schemes – narrowing the definition of large, mid and small cap equity schemes by market capitalisation as well as tightening definitions for debt and hybrid schemes. Up until now there were no standard definitions, which allowed for style drift and gave fund managers the leeway to change durations of their debt schemes. Do you think this is a step in the right direction? How will this help investors, and ratings firms such as Morningstar India? 
Globally, Morningstar has been categorising funds for over three decades and we have a fair grasp of the difficulties and nuances involved. While markets such as the UK, Canada and Thailand have had fund categories defined by the industry body, this move is historic in the sense of being the first attempt globally by a fund regulator to set defined categories and respective mandates.

While we applaud the regulator’s attempt to curb product proliferation by companies within a given category, we have taken cognizance of the blurred lines between some of the categories. Moreover, the dictum for a fund company to include only one scheme in each category is fairly restrictive, especially where clear style differences can co-exist between funds of a similar category.  

Having said that, this is a pro-investor move as it clearly defines the mandate for fund categories, which aids investors in identifying and comparing suitable investments with similar mandates. But the introduction of new categories increases the choice which leads to an additional dilemma of choosing the most suitable fund category.

Morningstar recently published the fifth GFIE study, which shows regulation and better practices are improving investor experiences worldwide. India shone in this study, joining the US in receiving top grades for disclosure. Could you highlight a few key areas where the Indian fund industry can improve? 
India is among the most expensive geographies when it comes to expense ratios especially for equity and allocation funds. Given the level of alpha that Indian funds deliver, there isn’t always enough focus on the absolute level of expenses charged by funds. We think as assets under management grow rapidly, asset managers should focus on passing on the benefits of economies of scale to investors by reducing expense ratios.

Another area for improvement is sales practises, namely the advisor versus distributor debate. At the heart of the debate is client interest and suitability. While the Investment Advisor Regulations of 2013 and subsequent amendments, look to address this issue, we are yet to see these practises being adopted widely. RIAs can offer investment and financial planning advice and be remunerated only by clients and not from commissions particularly on mutual funds. 
    
How will the emergence of artificial intelligence impact the fund industry globally? 
Artificial Intelligence is still in its infancy and has hurdles to overcome. However, the prospects for smarter trading, smarter data, and a more personalized experience through AI are immense. AI can be applied to create data sets, insights, systems, and new platforms for the fund industry.

At Morningstar, we are already using various forms of AI. Our integration of stock analyst content into Amazon’s Echo Dot, which uses the Alexa intelligent personal assistant, is an example of this. Through this integration, investors are able to consume Morningstar analyst content quickly and efficiently through the Alexa app. 
 
In 2012, the Indian regulator doled out monetary incentives to expand into smaller towns and cities. While this has helped, could you highlight other ways to expand the reach of the industry to the far-flung regions of the country? 
I believe that mutual fund assets have been concentrated in the large markets with around 80 per cent of the industry’s AUM coming from India’s 15 largest cities. One way to deepen penetration would be to increase the number of financial advisers in the industry. The number of active financial advisers in India, including IFAs, bank wealth managers and other national distributors, are little less than 200,000. In the US, there are more than 300,000 advisors with one-fourth of India’s population. 

Use of e-commerce platforms as a mutual fund distribution channel could increase the penetration of mutual funds in India, especially among young tech-savvy investors. E-commerce and robo-advice platforms, due to their extensive reach, can simplify the investment process and channelize small ticket investments from retail investors in smaller towns and rural areas.