Value Obsessed or Cost Obsessed

At the recently concluded AMFI (Association of Mutual Funds of India) conference at Mumbai, Deepak Parekh (HDFC group) predicted that the mutual fund (MF) aum would double in the next five years. But he also touched upon the sensitive topic of cost structure in the industry which he believes needs to come down along with better transparency levels.

The charges in the MF industry have been an area of debate in the recent past; this started when Morningstar, in its biannual study, suggested that the Indian MF industry’s charges were higher as compared to the 25 countries which were part of Morningstar study. This finding was rejected by the Foundation of Independent Financial Advisors (FIFA). It claims that among these 25 countries India is the third cheapest. We are not going to debate who is right and who is wrong. One thing is certain; the trajectory of cost is southward as the industry expands. At the same event Vijay Shekhar Sharma of Paytm announced that he would double the number of MF investors in the next three years. What he would bring to the table is low cost and real time transactions. This could be one of the catalysts (not the only one) to bring down costs.

Globally too fund management expenses are coming down. Some AMCs have announced zero expenses on the fund. The big factor playing out is passive funds, which are forcing active funds to closely look at expenses. In India passive funds have not caught the imagination of investors but it will happen eventually when active funds are unable to generate alpha for investors. Right now, despite the so-called higher expenses, the industry being able to generate alpha shows that investors need not worry much. MFs seem to be the best asset class for investors as other avenues like gold, real estate and fixed deposits are losing their attractiveness due to poor returns.

We believe that in the next decade the Indian MF industry cost would behave similarly to what happened in broking. In the 1990s brokers used to charge very high rates with little transparency in terms of at what price shares were bought and sold. That changed completely. Now we have brokerage rates as low as five paise and some even charge zero.

Three factors will drive costs down. First, passive investments would gain traction. Second, more competitors would mean that existing players would be forced to reduce costs. Third, technology will be an enabler to push costs down. A new business model could emerge where the advisor would charge fees for financial planning and the investor would move to a direct plan. But this is still 5-7 years away.

Despite the first MF scheme, launched by UTI, way back in 1964, the real action started only in 1993 when private players were allowed to offer services. But meaningful growth in terms of aum happened in the last couple of years where sips as well as AMFI’s campaign ‘Sahi hai’ resonated well with the investor.

At present we need to incentivise the distributor to expand the reach of MFs. We also need to hand hold investors till they understand the nuances of the MF. In that process if the industry is incurring higher expenses so be it. SEBI has anyway capped how much AMCs can charge a scheme as Total Expense Ratio (TER). It has pre-scribed rates in a graded manner which starts from 2.5 per cent – and keeps falling as the AUM keeps rising – to 1.75 per cent. This is for equity. For debt the slabs are 0.25 per cent lower than equity schemes. To expand MFs beyond the top 15 cities, SEBI has allowed 30 bps more if inflows come from beyond these 15 cities. The industry average for equity TER is in the region of 2.22 per cent while for debt it is about 1.65 per cent. What is encouraging is that this ratio has been falling over the years.

What the investor, as well as regulator, must understand is that we should be value obsessed rather than cost obsessed. The Indian MF industry has created good wealth for investors – despite the so-called high expenses charged by the AMC. The Indian MF industry is one of the most transparent when it comes to disclosures.

Instead of focusing too much on the expense ratio, the need of the hour is to ensure that the industry expands. As also financialisation of savings which can help India fund some ambitious projects. If Indian projects are funded by Indian investors it would change the pace of economy. And hence a few bps in expenses here and there would mean nothing. Let market forces decide what the MF industry should charge. The regulator should not strangle the industry when it is growing. For some reason if one scheme is charging higher fees as compared to others without offering differentiating returns obviously that scheme will become unpopular. Let market forces decide what expenses investors are willing to pay.