Investigation Into Mutual Funds In India Finance Essay - Free Essay Example

India is the fastest growing market for mutual funds since 2004 with a CAGR of 29% in the 5-year period from 2004 to 2008 as against the global average of 4 %. The increase in revenue and profitability however has not been proportionate with the AUM growth in the last 5 years. Low share of global assets under management, low penetration levels, limited share of mutual funds in the household financial savings the climbing growth rates in the last few years are amongst the highest in the world. FUTURE OUTLOOK IN A DYNAMIC ENVIRONMENT According to KPMG India the industry AUM is likely to grow at 15 to 25% from the period 2010 to 2015 based on the pace of the economic growth. In case of a quick economic recovery +ve reinforcement of growth drivers identified, KPMG has a view that the Indian mutual fund industry will grow at the rate of 22 to 25% in the period from 2010 to 2015, resulting in AUM of INR 16,000 to 18,000 billion in 2015. In case of a relatively slower economic revival, KPMG is of the view that the Indian mutual fund industry may grow in the range of 15 to 18 % in the period from 2010 to 2015, resulting in AUM of INR 15000 to 17000 billion in 2015. MUTUAL FUND INTRODUCTION A mutual fund is a form of collective investment that group money from many investors and invests the money in bonds, stocks, short-term money-market instruments other securities. This investment vehicle is pooling money from the common man is diversifying into other investment opportunities. The mutual funds are managed by Financial institutions or the companies. In India they are regulated by Institutions such as Asset Management Companies. Professionals are hired in these companies for evaluating the Balance Sheet and P L accounts of different companies .This is done to know the performance of companies to know which will succeed in the near future. This will bring high returns to the investment. Mutual Funds are invested in more subtle companies that have a steady growth rate are not much affected by the share market. Investments are not only made in equities, debentures which are directly interrelated to the bullish bearish trends of the market. This is the advantage of mutual funds over banks allows investors other options to invest in safe, low risk companies. The investors can invest in different schemes of one fund or in altogether different mutual funds can build their own investment portfolio. The flow chart describes broadly the working of a mutual fund: TYPES OF MUTUAL FUNDS EQUITY ORIENTED SCHEMES (Growth Schemes) These schemes invest a majority of their funds in equities and a small portion in money market instruments. Such schemes have the potential of delivering superior returns in long run. But in the short term, these schemes are exposed to fluctuations in value because they invest in equities. Equity schemes are hence not suitable for investors seeking regular income or want to use their investments in the short term. They are ideal for investors who have a long term investment prospect. These schemes include: General purpose Sector specific Index schemes Sector schemes Tax saving schemes Real estate funds DEBT BASED SCHEME (Income Schemes) According to it, investment is done in debt securities such as corporate bonds, debentures and government securities. The prices of these schemes tend to be more stable compared with the equity schemes and most of the returns to the investors are generated through dividends or steady capital appreciation. These schemes are ideal for retired or conservative investors who do not prefer to take higher equity risks. Income Schemes Money Market Schemes Gilt Fund HYBRID SCHEMES These schemes are commonly known as balanced schemes. These schemes invest in both Equity as well as Debt. By investing in such a scheme, balanced schemes are formed which fulfils the objective of income also moderate capital appreciation. These are ideal for investors with a conservative long term orientation. AS PER CONSTITUTION OPEN -ENDED MUTUAL FUNDS An open-ended fund does not have a fixed maturity period. On any business day, investors can buy or sell units from and to the mutual fund at NAV-related prices. These schemes have unlimited capitalization with no limit on the amount one can buy from the fund. And thus, the unit capital can keep growing. Generally these funds are not listed on any exchange. CLOSE-ENDED MUTUAL FUNDS Close-ended schemes have fixed maturity periods. Investors can buy these funds when these funds are open in the initial issue after that they cannot issue new units except in case of rights issues or bonus. But after the initial issue, one can buy or sell the units of the scheme on the stock exchanges where they are listed. The market price of the units could vary from the NAV of the scheme due to demand and supply factors, investors expectations and other market factors. INTERVAL SCHEME These schemes combine the features of open-ended and close-ended schemes. They can be traded on the stock exchange or can be open for sale or redemption during pre-determined intervals at NAV based prices. AN OVERVIEW OF THE INDUSTRY INDIAN CONTEXT The Indian mutual fund industry has evolved from a single player monopoly in 1963 to a fast growing, competitive market on the back of a strong regulatory framework. The mutual fund industry in India started in 1963 with the formation of Unit Trust of India, at the initiative of the Government of India and the Reserve Bank of India. The mutual funds history in India can be broadly classified into 4 distinct phases. First Phase 1964-87 Second Phase 1987-1993 (Entry of Public Sector Funds) Third Phase 1993-2003 (Entry of Private Sector Funds) Fourth Phase since February 2003 AUM Growth The Assets under Management (AUM) have grown at a rapid pace over the past few years, at a CAGR of 35 percent for the five-year period from 31 March 2005 to 31 March 2009. Over the 10-year period from 1999 to 2009 industry grew at 22 percent CAGR encompassing varied economic cycles. This growth was despite 2 falls in the AUM the first being after the year 2001 due to the dotcom bubble burst, and the second in 2008 consequent to the global economic crisis (the first fall in AUM in March 2003 arising from the UTI split). Growth in AUM in the Indian Mutual Fund Industry (Average AUM in INR) Billion) AUM Base and Growth Relative to the Global Industry India has been amongst the fastest growing markets for mutual funds. In the five-year period from 2004 to 2008 (as of December) the Indian mutual fund industry grew at 29 % CAGR as against the global average of 4 %. Over this period, the mutual fund industry in mature markets like the US and France grew at 4 percent.However, despite clocking growth rates that are amongst the highest in the world, the Indian mutual fund industry continues to be a very small market, comprising 0.32 percent share of the global AUM of USD 18.97 trillion as of December 2008. AUM to GDP Ratio The ratio of AUM to Indias GDP has increased from 6 percent in 2005 to 11 percent in 2009. However despite this, it continues to be significantly lower than the ratio in developed countries, where the AUM accounts for 20-70 percent of the GDP. AUM to GDP Ratio for India Profitability The increase in revenue and profitability in the Indian mutual fund industry has not been proportionate with the AUM growth in the last 5 years. The AUM grew at 35 percent CAGR in the period from March 2005 to 2009, while the profitability of AMCs which is defined as PBT as a percentage of the AUM declined from 24 bps in FY 2004 to 14 bps in FY 2008. During FY 2004 and FY 2008, the investment management fee as a percent of average AUM was in the range of 55 to 58 bps (small increase to 64 bps in FY 2006) due to the industry focus on the underlying asset mix comprising relatively low margin products being targeted at the institutional segment. The operating expenses, as a %age of AUM, rose from 41 bps in FY 2004 to 113 bps in FY 2008 largely due to the increased spend on marketing, distribution and administrative expenses impacting AMC margins. The increasing cost pressures and declining profitability had a great impact on the entry plans of global players eyeing an Indian presence. The growth in AUM accompanied by a decline in profitability necessitates an analysis of the underlying characteristics that have a bearing on the growth profitability of the Indian mutual fund industry. Industry Structure The Indian mutual fund industry currently consists of 38 players that have been given regulatory approval by SEBI. The industry has witnessed a shift drastically in favour of private sector players, as the number of public sector players reduced from 11 in 2001 to 5 in 2009. The public sector has gradually ceded market share to the private sector. Public sector mutual funds comprise 21 percent of the AUM in 2009 as against 72 percent in 2001. Regulatory Framework The Indian mutual fund industry in terms of regulatory framework is believed to match up to the most developed markets globally. The regulator, Securities and Exchange Board of India (SEBI), has consistently introduced several regulatory measures and amendments aimed at protecting the interests of the small investor that augurs well for the long term growth of the industry. The implementation of Prevention of Money Laundering (PMLA) Rules, the latest guidelines issued in December 2008, as part of the risk management practices and procedures is expected to gain further momentum. The current Anti Money Laundering (AML) and Combating Financing of Terrorism (CFT) measures cover two main aspects of Know Your Customer (KYC) and suspicious transaction monitoring and reporting. MUTUAL FUND INVESTING STRATEGIES: Systematic Investment Plans (SIPs) SIPs require an investor to invest a fixed sum of money at regular intervals in the Mutual fund scheme he has chosen. It is best suited for young people who have started their careers and need to build their wealth. Systematic Withdrawal Plans (SWPs) An investor invests in a mutual fund scheme is allowed to withdraw a fixed sum of money at regular intervals to take care of his expenses. These plans are best suited for people nearing retirement. Systematic Transfer Plans (STPs) This plan allows the investor to transfer on a periodic basis a specified amount from one scheme to another within the same fund family ie., 2 schemes belonging to the same mutual fund. This service allows the investor to manage his investments actively to achieve his objectives. Many funds do not even charge any transaction fees for this service an added advantage for the active investor. RATE OF RETURN ON MUTUAL FUNDS:- An investor in mutual fund earns return from two sources: Income from dividend paid by the mutual fund. Capital gains by selling the units at a price higher than the acquisition price. PERFORMANCE MEASURES OF MUTUAL FUNDS: The past performance alone cannot be indicative of future performance. The present is the only quantitative way to judge how good a fund. Therefore, there the past performance of different Mutual Funds should be correctly assessed. Worldwide, good Mutual Fund companies are known by their AMCs and this fame is directly linked to their superior stock selection skills. For Mutual Funds to grow, AMCs must be held accountable for their selection of stocks. In other words, there must be some performance indicator that will reveal the quality of stock selection of various AMCs. The most important measures of performance are: Standard Deviation Beta Value The Treynors Measure The Sharpe Measure Jenson Model Fama Model Standard Deviation:- It throws light on a funds volatility in terms of rise and fall in its returns. The maximum volatility in a security is the riskiest brings about unevenness in its performance. This risk is measured by Standard deviation of a fund by measuring the degree to which the fund fluctuates in relation to its mean return. Beta Value:- Beta determines the volatility or risk of a fund in comparison to that of its index or benchmark. A fund with a beta value close to 1 means that the funds performance matches closely to the index or benchmark. A beta 1 indicates greater volatility than the overall market, and a beta 1 indicates less volatility than the benchmark. If, for example, a fund has a beta of 1.10 in relation to the Sensex, then the fund has been moving 10% more than the index. Therefore, if the Sensex has increased 15%, the fund would be expected to increase 16.5%. Treynor Ratio:- This ratio evaluates funds on the basis of Treynors Index. This Index is a ratio of return generated by the fund over and above risk free rate of return (generally taken to be the return on securities backed by the government, as there is no credit risk associated), during a given period and systematic risk associated with it (beta). It isrepresented as: Treynors Index (Ti) = (Ri Rf)/Bi. where { Ri represents return on fund, Rf is risk free rate of return Bi is beta of the fund } All risk-averse investors would like this value to be maximum. While a high positive Treynors Index specifies a better risk-adjusted performance of a fund and a low negative Treynors Index is an indication of unfavorable performance. The Sharpe Measure :- The performance of a fund is evaluated on the basis of Sharpe Ratio which is a ratio of returns generated by the fund over above risk free rate of return the total risk associated with it. The investors are concerned about the total risk of the fund. So, it evaluates funds on the basis of reward per unit of total risk. It can be written as: Sharpe Index (Si) = (Ri Rf)/Si Where { Si is standard deviation of the fund, Ri represents return on fund Rf is the risk free rate of return } A high and +ve Sharpe Ratio specifies a superior risk-adjusted performance of a fund a low and -ve Sharpe Ratio indicates unfavourable performance. Comparison of Sharpe and Treynor The total risk (Sharpe measure) is appropriate for evaluating the risk return relationship for well-diversified portfolios. the systematic risk (Treynor measure) is the relevant measure of risk for evaluating less than fully diversified portfolios or individual stocks. The total risk is equal to systematic risk for a well-diversified portfolio. Rankings based on both the risks should be identical for a well-diversified portfolio since the total risk is reduced to systematic risk. So, a poorly diversified fund that ranks higher on Treynor measure when compared with another fund that is highly diversified, will rank lower on Sharpe Measure. Jenson Model:- This measure is also known as the differential Return Method. It involves evaluation of the returns generated by the fund vs. the returns actually expected out of the fund1 given the level of its systematic risk. The surplus between the 2 returns is known as Alpha, which measures the performance of a fund compare to the actual returns over the period. Required return of a fund at a given level of risk (Bi) can be calculated as: Ri = Rf + Bi (Rm Rf) Where { Ri represents return on fund, Rm is average market return during the given period, Rf is risk free rate of return Bi is Beta deviation of the fund } After calculating it, Alpha = the actual return of the fund -required return(Ri) The superior performance of the fund is represented by higher alpha and vice versa. Limitation of this model is that it considers only systematic risk not the entire risk associated with the fund and an ordinary investor cannot mitigate unsystematic risk, as his knowledge of market is primitive. Fama Model:- It is an extension of Jenson model. This model takes the difference between the performance measured in terms of returns of a fund the required return commensurate with the total risk associated with it as a measure of the performance of the fund and is called Net Selectivity. The Net Selectivity represents the stock selection skill of the fund manager, as it is the excess returns over and above the return required to compensate for the total risk taken by the fund manager. Higher value indicates that fund manager has earned returns well above the return corresponding to the level of risk taken by him. Required return can be calculated as: Ri = Rf + Si/Sm*(Rm Rf) Where { Ri represents return on fund, Sm is standard deviation of market returns, Rm is average market return during the given period Rf is risk free rate of return } The Net Selectivity is calculated as ,actual return of the fund-required return. Among the above performance measures, two models namely, Treynor measure and Jenson model use Systematic risk is based on the premise that the Unsystematic risk is diversifiable. These models are suitable for large investors like institutional investors with high risk taking capacities as they have large funds can invest in a number of options to dilute some risks. They can spread their portfolio across a number of stocks and sectors. However, Sharpe measure and Fama model which consider the entire risk associated with funds are suitable for small investors since the ordinary investor lacks the necessary skill and resources to diversify. Moreover, fund manager will help in safeguarding the money invested to a great extent by selecting the fund on the basis of their superior stock selection ability BENEFITS OF MUTUAL FUND There are numerous benefits of investing in mutual funds and one of the key reasons for its phenomenal success in the developed markets like US and UK is the range of benefits they offer, which are unmatched by most other investment avenues. The key benefits are explained in this section. AFFORDABILITY An investor can buy in to a portfolio of equities, which would otherwise be extremely expensive. Each unit holder thus gets an exposure to these portfolios with an investment as low as Rs.500/-. This amount would get you less than quarter of an RIL share! Therefore, an investor can build a portfolio easily through a mutual fund by investing directly in the stock market. DIVERSIFICATION It simply means that you can spread your investment across different securities (stocks, bonds, money market instruments, real estate, etc.) and different sectors (auto, textile, telecommunication, information technology etc.). This kind of a diversification may add stability to ones returns, for example equities might underperform during a period of time but bonds and money market instruments might perform well enough to offset the effect of a bend in the equity markets. Similarly the telecommunication sector might be faring poorly but the auto and information technology sectors might do well and may help you meet your return objectives. VARIETY Mutual funds offer a great variety of schemes. This variety is beneficial in two ways: It offers different types of schemes to investors with different needs and risk appetites. It allows an investor to invest sums across a variety of schemes, both debt and equity. PROFESSIONAL MANAGEMENT When we buy in to a mutual fund, we are handing our money to an investment professional that has experience in making investment decisions. Therefore, it is his job to (a) find the best securities for the fund meeting the funds stated investment objectives (b) keep track of investments and changes in market conditions adjust the mix of the portfolio as and when required. TAX BENEFITS In case of Individuals and Hindu Undivided Families, a deduction unto Rs. 9,000 from the Total Income will be acceptable in respect of income from investments specified in Section 80L, including income from Units of the Mutual Fund. REGULATIONS Securities Exchange Board of India (SEBI) is the mutual funds regulator has clearly defined rules, which govern mutual funds. These rules relate to the formation, administration and management of mutual funds also set disclosure and accounting requirements. Therefore, the interest of investors is protected by such a high level of regulation. LIQUIDITY In open-ended mutual funds, all or part of the units can be redeemed at any time. Some schemes do have a lock-in period where an investor cannot return the units until the termination of such a period. CONVENIENCE An investor can conveniently purchase or sell fund units directly from a fund, through a broker or a financial planner. The investor may select a Systematic Investment Plan (SIP) or a Systematic Withdrawal Advantage Plan (SWAP). In addition to this account statements and portfolios of the schemes are send to the investor. MUTUAL FUND PLAYER IN INDIA HDFC Mutual Fund A Case Study HDFC ASSET MANAGEMENT COMPANY LTD (AMC) HDFC AMC, incorporated under the Companies Act, 1956 was approved to act as an AMC for the Mutual Fund by SEBI on July 30, 2000. As per the terms of the Investment Management Agreement, the AMC will conduct the operations of the MF manage assets of the schemes, including the schemes launched from time to time. In terms of the investment Management Agreement, HDFC Asset Management Company Ltd. is appointed to manage the Mutual Fund. The paid up capital of the AMC is Rs. 25.161 crore. HDFC Mutual Fund booked a profit of Rs 1,388 crore in 2009-10 in 1st half is at no. 2 position. As on 30 October 2009 Avg. AUM is Rs. 93315.98 cr. No. of investors is 3290456 No. of ARN certified distributors is 33659 The present equity shareholding pattern of the AMC : Particulars % of the paid up equity capital Housing Development Finance Corp. Ltd 60 Standard Life Investments Ltd 40 EQUITY SCHEMES ( some of them includes) HDFC GROWTH FUND Investment Objective The primary investment objective of this scheme is to generate long term capital appreciation from a portfolio that is invested predominantly in equity equity related instruments. Basic Scheme Information Then nature of scheme Open Ended Growth scheme Inception Date September 11, 2000 Plan Dividend Option, Growth Option Exit Load (%age of the Applicable NAV) Nil Min. Application Amt. Rs 5000 in multiples of Rs 100 thereof to open an account/portfolio. Additional purchases is Rs 1000 in multiples of Rs 100 thereof. Lock In Period Nil NAV Periodicity Every Business Day Redemption Proceeds Normally despatched within 3 business days Investment pattern The quantity of the Scheme will be invested primarily in equity and equity related instruments. According to it, investment might be a part of its quantity in debt and money market instruments in order to manage its liquidity requirements from time to time under certain circumstances to protect interests of the Unit holders. The asset allocation under the Scheme will is as follows SNO. TYPE OF INSTRUMENTS NORMAL ALLOCATION (% of net asset) RISK PROFILE 1 Equities Equities related instruments 80-100 Medium high 2 Debt securities, money market instruments cash 0-100 Low medium Investment Strategy Risk Control The investment approach will be based on a set of well established flexible principles that emphasise the concept of sustainable economic earnings cash return on investment as the means of valuation of companies. The objective will be to identify businesses with superior growth prospects good management at a reasonable price. HDFC TAX SAVER Investment objective To achieve a long term growth of capital. Basic Scheme Information Nature of scheme Open Ended Equity linked saving scheme Inception Date March 31, 1996 Plan Dividend Options, Growth Options Exit Load ( % age of the Applicable NAV) Nil Min Application Amt. Rs.5000 and in multiples of Rs.100 thereof to open an account / portfolio Lock In Period 3 years NAV Periodicity Every Business Day Redemption Proceeds Normally despatched within 3 Business days Investment Pattern The asset allocation under the Scheme will IS as follows: SNO. ASSET TYPE %AGE OF PORTFOLIO RISK PROFILE 1 Equities and Equities related instruments Min 80% Medium high 2 Debt securities, cash money market instruments Min 20% Low medium Investment in Securitized debt would not exceed 20% of the net assets of the scheme. The Scheme may also invest up to 25% of net assets of the scheme in derivatives such as Futures Options other such derivative instruments introduced from time to time for the purpose of hedging portfolio. RECOMMENDATIONS TO MUTUAL FUND COMPANIES Given that customer awareness is the pre-requisite for the achievement of the industry growth potential, there is a need for planning, financing and executing initiatives aimed at increasing financial literacy and enhancing investor education across the entire country through a sustained collaborative effort across all stakeholders. Financing a Sustainable Nationwide Customer Awareness Program Promoting Financial Planning Awareness in Educational Institutions Introduction of Customer Friendly Products and Product Features Pricing Flexibility Opening Up of the Public Sector Branch Network in Tier-3 Tier-4 cities Focus on Increasing Customer Engagement Pre and Post Completion of the Investment SUMMARY There is a perceived need to review risk and performance analysis capabilities and governance structures, to meet fiduciary responsibilities and the increasing demand for transparency. AMCs therefore need to re-orient their business towards fulfilling customer needs. As customers seek trusted advisors, the manufacturer-distributor-customer relationship is expected to be centred not on the sale of products, but for collectively promoting the financial success of customers across all facets of their professional and personal lives. This requires creating a collaborative network of experts in funds management and financial advice, innovative product offerings, efficient service delivery and supporting technology. The mutual fund industry today needs to develop products to fulfil customer needs and help customers understand how its products cater to their needs. Given that the industry needs to collectively work towards riding over the dynamic and relatively less favourable economic environment at present, the next phase for the industry is likely to be characterised by a stronger focus on customer centricity. Other areas of focus are likely to be cost management and enabling strong governance and regulatory framework all aimed at helping the industry achieve sustained, profitable growth, going forward. With regards to HDFC Mutual Fund, the growth story is quite promising and the AUM under its purview is improving at a good rate. The brand equity, extensive distribution channel and investor-friendly products make it one of the most sought after investment opportunity. And, with all its commitment in line with the industry growth story and future potential, HDFC Mutual Fund is expected to hold its position firmly in the business.