G N Bajpai: Missing the wood for the trees

Mutual funds should not lose sight of the retail customer.

The capital market is galloping ahead. The Sensex is on a flight of fancy; rising from below 3,000 to over 10,000 in less than three years and delivering returns unmatched in the emerging markets and unprecedented in Indian history. The bulls are surprised and bears shocked.

The level of interest in the Indian capital market from across jurisdictions is amazing. Average annual FII flows over the past three years total $10 billion. A late bloomer like Japan has gathered pace and raised India-dedicated funds aggregating $3 billion. All this has resulted in the Indian capital market becoming the most expensive in Asia. Yet it remains the most preferred--thanks to the quality of the market, macro-economic stability and the prospect of continued economic expansion.

The equity portfolios of mutual funds have enjoyed a dramatic increase of 74 per cent, from Rs 28,640 crore to Rs 67,352 crore (AMFI data) in just eight months of the current financial year, contributed both by new collections and rise in valuations. Funds are set to reap record profits of Rs 850 crore in 2005-06, as against Rs 250 crore last year (Business Standard: December 28). Structurally and financially, 2005-06 should turn out to be a very satisfying year for fund managers and for the shareholders of asset management companies.

When things look this good for fund managers, why should they worry about the future, or look for alternative growth strategies? And yet, the Indian economy is on a sustainable, high-growth trajectory. Household savings have grown from 16.96 per cent of GDP in 1991-92 to 24.34 per cent in 2004-05 and are still rising. The pool of annual disposable resources has grown six-fold from Rs 1,10,736 crore to Rs 6,71,692 crore. Until 1991, Unit Trust of India (UTI) had a monopoly on the mutual fund industry. UTI's track record in mobilising household savings was fairly satisfactory, with a compound annual growth rate of 42.56 per cent (from 0 in 1964 to Rs 59,618 crore in 1995). In fact, in 1995 UTI created a flutter. Its assets under management (AUM) in that year came close to overtaking in size the Rs 59,978 crore Life Fund (LF) of Life Insurance Corporation of India (LIC), which at that time defined the entire life insurance sector. Indeed, the aggregate AUM of the mutual fund sector was greater than the Life Fund of the insurance industry in that year. So it is worthwhile noting that currently the Life Fund is estimated to be nearly three times the size of assets under management by the entire mutual fund industry. The road to growth of the two industries has diverged.

Where did the mutual fund industry go wrong? The entry of the private sector and of globally successful asset management companies, it had been predicted, would set in motion an explosive expansion of the mutual fund industry. Unfortunately, that was not to be. The truth is that investors' confidence was shaken by major market misconduct during the bull phase of 2000-01, and the market turned moribund. Also, building a distribution network is an expensive preposition and instruments with guaranteed returns are not permitted by the regulator.

Meanwhile, new entrants in the mutual fund industry brought with them not just investment skills and technology, but also the ethos of focusing on bulk business. That India is not North America or Western Europe was overlooked. Large pension funds, university endowment funds, high net worth individuals et al. are conspicuously absent here. India's social security system is not only primitive but has developed on the theme of lump sum payments, against the contrasting pattern of annuity payments in the mature economies. And the provident funds (PF), which hold a lot of long-term money, are not allowed to invest in equity.

It so happens that, while this was going on, the internal accruals of the corporate sector during the business restructuring and re-engineering phase had to be channelled into optimally chosen treasury outlets before being ploughed back into the core business. The tax breaks on offer landed them in the lap of the mutual fund industry. The fight for that slice of the business became so fierce that operators had to run to the regulator for cover, seeking a ban on under-cutting and rebating, which had become rampant.

Even today, asset management in India is a retail business and it will be quite a while before institutions with bulk money shape up as major clients. A few star-struck fund managers are betting on the pension sector, without appreciating that even after the sector is opened up, it will take years before a sizeable fund gets accumulated, and then this money will be shared by several players. It is as well to remember that until FIIs arrived on the scene, the Indian capital market was led by individual, small investors. And whenever these retail investors took a pause, the market lapsed into hibernation.

The correct strategy, therefore, would be to create an extensive distribution network (owned, hired or a mix of both) to mobilise retail money. Competition in this part of the market is not fierce and rebating is not rampant. With the dismantling of administered interest rates, investors have started looking for alternative avenues for investing their money. Since the mutual fund industry did not reach out, this money is flowing into the capital market through unit-linked insurance schemes launched by the life insurance companies.

What the future holds for mutual funds can be gauged from the enormity of the size of savings available, and their propensity to flow into the capital market. GDP is growing at an annual growth rate of 11-12 per cent (real growth plus inflation) and a World Bank study estimates that household savings are growing at an even more rapid 39 per cent; by 2010, these savings are predicated to total Rs 17 trillion (Rs 17 lakh crore) per year. Where will this money go? With the sources that have so far delivered high-yielding returns drying up, the real opportunities for a reasonable rate of return will lie in the capital market. Hence, financial flows into this market will increase. If the mutual fund industry organises itself well, it is reasonable to expect that 10 per cent of household savings, i.e. Rs. 1.7 trillion (nearly the current size of AUM), will pour into the capital market annually by 2010.

Is the mutual fund industry gearing up to handle these sums? And will the capital market be deep and wide enough to absorb such quantities of money? This is the key question that the mutual fund industry has to ask itself. Also, chasing bulk money from institutional clients may be more profitable today, but getting in retail money leads to a steadier business. Chasing bulk money in preference to retail disposable incomes, therefore, will be like missing the wood for the trees.

The author is former chairman of Sebi and LIC