136

CHAPTER: 4

INDIAN FINANCIAL SYSTEM AND MUTUAL FUNDS

Introduction

Financial System in India

Brief Review: Behaviour of Households towards Mutual Funds and

other Investment Options Available

Investors‟ Preference for Mutual Fund Organization

Investors‟ Preference among Types of Mutual Fund Schemes

Impact Of Mutual Fund‟s Growth on Financial Market and its

Components

137

CHAPTER: 4

INDIAN FINANCIAL SYSTEM AND MUTUAL FUNDS

4.1 INTRODUCTION

The economic and financial scenario of India prior to 1991 was somehow not optimistic.

Indian economy at that time was suffering from low savings, low GDP, high inflation,

high unemployment, high rates of interest, low forex reserve, etc.. When India

approached IMF for financial assistance in 1991, we were imposed certain conditions on

the basis of which the financial assistance was sanctioned to India. These restrictions

which we accepted under the pressure from IMF were actually the starting point of

economic reforms popularly known as LPG process. The fruit of liberalisation reached

their peak in 2007, when India recorded its highest GDP growth rate of 9%.36

With this,

India became the second fastest growing major economy in the world, next only to

China37

. The growth rate has slowed significantly in the first half of 2012.38

An

Organisation for Economic Co-operation and Development (OECD) report states that the

average growth rate 7.5% will double the average income in a decade, and more reforms

would speed up the pace.39

India's Gross domestic product (GDP) growth rate became

lowest in 2012-13 over a decade, growing merely at 5%,40

more criticism of India's

economic reforms surfaced, as it apparently failed to address employment growth,

nutritional values in terms of food intake in calories, and also exports growth - and

thereby leading to a worsening level of current account deficit compared to the prior to

the reform period.41

36

http://timesofindia.indiatimes.com/india/Indias-income-inequality-has-doubled-in-20-

years/articleshow/11012855.cms 37

GDP growth slumps to 5%, a decade‘s low, Hindu Business Line 31st May 2013 38

India‘s Ponzi-styled economic reforms run out of steam, East Asia Forum 4th June, 2013 39

Kelegama, Saman and Parikh, Kirit (2000). Political Economy of Growth and Reforms in South Asia. Second

Draft. 40

"Redefining The Hindu Rate of Growth". The Financial Express. 41

"Industry passing through phase of transition". The Tribune India.

138

By 2008, India had established itself as one of the world's fastest growing economies.

Growth significantly slowed to 6.8% in 2008–09, but subsequently recovered to 7.4% in

2009–10, while the fiscal deficit rose from 5.9% to a high 6.5% during the same period.42

India's current account deficit surged to 4.1% of GDP during Q2 FY11 against 3.2% the

previous quarter. The unemployment rate for 2010–11, according to the state Labour

Bureau, was 9.8% nationwide.43

As of 2011, India's public debt stood at 68.05% of GDP

which is highest among the emerging economies.44

However, inflation remains

stubbornly high with 7.55% in August 2012, the highest amotrade (counting exports and

imports) stands at $606.7 billion 45

and is currently the 9th largest in the world. During

2011–12, India's foreign trade grew by an impressive 30.6% to reach $792.3 billion

(Exports-38.33% & Imports-61.67%). The economy of India is the ninth-largest in the

world by nominal GDP and the third-largest by purchasing power parity (PPP).46

All these developments could have not been possible without the sound financial market.

It is the financial market which finances economic development. It is the financial market

which channelizes the saving of the people into the investment. Indian financial markets

are getting more and more institutionalized. Foreign investors, local institutions and

mutual funds are now playing a bigger role. Mutual funds play a significant role in the

development of the financial market and this has been proved in the developed countries

like United States, United Kingdom and Japan. India is at its first stage of a revolution

that has already peaked in United States. In United States, the asset base of mutual funds

is much higher than its bank deposits. In India, mutual funds‘ assets are not even 10% of

the bank deposits, but this trend is only at the beginning.

The mutual funds in India have emerged as strong financial intermediaries and are

playing a very important role in bringing stability to the financial system and efficiency

42

Economic Survey 2010, pp. 1–2. 43

"Report on Employment & Unemployment Survey (2009–10)". Bureau of Labor Statistics, Indian Government. 8

October 2010. Retrieved 2011-01-17. 44

Public debt, IMF, accessed on 29 April 2011. 45

"Exports record an impressive 57% growth in May". The Hindu (Chennai, India). 10 June 2011. 46

"India". International Monetary Fund. Retrieved 2013-04-16.

139

to resource allocation. Mutual funds help corporates in raising funds for their financial

needs and provide an avenue of investment to investors by parking their savings. This

leads to the overall growth of the economy. The major chunk of the household savings in

India, which earlier went to bank deposit are now being taken by mutual funds. The

active involvement of mutual funds in promoting economic development can be seen not

only in terms of their participation in the savings market but also in their dominant

presence in the money and the capital market.

A developed financial market is critical to build overall economic development and

mutual funds play an active role in promoting an active healthy market. Mutual funds

increase liquidity in the money market. The asset holding pattern of mutual fund in India

indicates the dominant role of the mutual funds in the money and capital markets. The

private corporate sector in India is a deficit sector and the gap between demand and

supply of financial resources is met by funds raised through loans, advances and issuance

of securities. However, the buoyancy in the capital market has increased the reliance of

the corporate sector has more than doubled. The changing pattern of corporate financing

indicates that the banking sector is losing its prominence vis-a-vis the other financial

sector. Direct financing by mutual funds to the corporate sector has substantially

increased after SEBI guidelines allowed‘ the corporate sector to reserve 20% of the

public issues for Indian mutual funds.

Mutual funds have also widened the private placement market for corporate securities.

Mutual funds have enabled the corporate sector to raise capital at reduced costs and have

opened an avenue for alternate source of capital. Mutual funds in India have merged as a

critical institutional linkage among various financial segments like savings, capital

market and the corporate sector. As various tax incentives and benefits on mutual fund

investment are offered by the Government, their role in the mobilization of savings and

the development of the economy will assume more significance. They provide much

needed impetus to the money market and the stock markets, in addition to direct and

indirect support to the corporate sector.‖ Above all mutual funds have given a new

140

direction to the flow of personal savings and semi-urban areas to reap benefits of stock

market investments. Indian mutual funds are thus playing a very crucial development role

in allocating resources in the emerging market economy.

By 2012, there are 49 registered mutual funds managing ₨5, 87,216, according to the

data published by the Association of Mutual Funds of India (AMFI). Mutual funds saw

record resource mobilization as investors lined up to take advantage of the stock market

boom. This chapter aims at analyzing the significant role played by the Mutual Funds in

Indian financial market by channelizing the saving of the investors (mostly of retails

investors) into the investment in corporate.

4.2 FINANCIAL SYSTEM IN INDIA

141

Figure 4.1: INTERRELATION- FINANCIAL SYSTEM AND ECONOMY

FINANCIAL

SYSTEM

SAVERS

LENDERS

INVESTORS

BORROWERS

CORORATE

SECTOR GOV.

SECTOR

UNORGANIZED-

SECTOR

ECONOMY

HOUSEHOLDS FOREIGN

SECTORS

142

In order to critically examine the role of mutual funds in Indian financial market, we

should first of all have a good idea about the Indian financial system. The financial

system in India comprises of financial institutions, financial markets, financial

instruments and services. Financial market refers to those places where financial assets

are created and traded. Financial assets represent a claim for the payment of principal

amount some times in future date and for periodic payment of money in the form of

interest or dividends. The Reserve Bank of India (RBI) as the main regulator of credit is

the apex institution in the financial system. Other important financial institutions are the

commercial banks (in the public and private sector), cooperative banks, regional rural

banks and development banks. Non-bank financial institutions include finance and

leasing companies and other institutions like LIC, GIC, UTI, Mutual funds, Provident

Funds, Post Office, Banks etc.. The banking system is, by far, the most dominant segment

of the financial sector accounting for over 80 per cent of the funds flowing through the

financial sector. The Indian financial sector reforms aim at improving the productivity

and efficiency of the economy. It remained stable, even when other markets in the Asian

143

region were facing a crisis. The opening of the Indian financial market to foreign and

private Indian players has resulted in increased competition and better product offerings

to consumers. The main function of all these financial institutions is financial

intermediation i.e., facilitating the flow of saving from common man to industrial houses.

In the initial stages, the role of the intermediary was mostly related to ensure transfer of

funds from the lender to the borrower. This service was offered by banks, FIs, brokers,

and dealers. However, as the financial system widened along with the developments

taking place in the financial markets, the scope of its operations also widened. Some of

the important intermediaries operating in the financial markets include investment

bankers, underwriters, stock exchanges, registrars, depositories, custodians, portfolio

managers, mutual funds, financial advertisers, financial consultants, primary dealers,

satellite dealers, self-regulatory organizations, etc..

Financial Markets are mainly classified as Money Market and Capital Market. The term,

‗money market‘ is used to denote the financial institutions which deal with the short term

borrowing and lending of money. The term, ‗capital market‘ is used to mean the institutes

which deals with the lending and borrowing of long-term money. Resource mobilization

by mutual funds is an important activity in the capital markets. India‘s mutual fund and

stock market have witnessed phenomenal growth over the last few years. According to a

study, mutual funds would be one of the major instruments of wealth creation and wealth

saving in the years to come, giving positive results. As India is targeting a GDP growth

rate of 9 % in the Eleventh Plan Period, the role of financial sector as well as the role of

mutual funds industry in India as an important segment of financial market for resource

mobilization in capital market is going to be very significant. The consistency in the

performance of mutual funds has been a major factor that has attracted many investors.

The mutual fund industry growth is estimated at about 50 per cent, much higher than that

of bank fixed deposits which are growing at about 20 per cent.

144

4.3 BRIEF REVIEW: BEHAVIOUR of HOUSEHOLDS TOWARDS MUTUAL

FUNDS and OTHER INVESTMENT OPTIONS AVAILABLE

The standard explanation of the investment allocation includes safety of the principle,

assured returns, adequate magnitude of the return and growth in return commensurate

with rate of inflation. The pattern of allocation to a large extent can be influenced by

demographic characteristics, such as occupation, income, age, dependency ratio and

education. Other factors that affect allocation include information and economic stability.

In this section we profile the behaviour of the household that is germane to the choices

made while allocating surplus income across various investment options.

Households have diversified their investment portfolios. The options available for

investment include mutual funds, bonds, debentures, IPO, derivatives and the secondary

markets.

Figure 4.2: DISTRIBUTION OF INVESTMENT ACROSS VARIOUS

INSTRUMENTS

(Source: NACER Report 2010-11)

145

From the above figure 4.2 we find that mutual funds constitute the single largest

allocation (40.8 per cent) compared to all other options. Since mutual funds provide

returns that are in general greater than market returns and expose investing households to

risks that are lower than the market risks, the households of various strata prefer this

medium over retail investing. Retail investing is "costlier" in terms of time and

information as well as the variability of returns. This explains why a mere 21.25 per cent

of all households prefer to invest in the secondary market. Other choices such as

derivatives and bonds are even less preferred.

Figure 4.3: Choice of Investment by Marital Status

(Source: NACER Report 2010-11)

146

Figure4.4: Choice of Investment by

Occupation

(Source: NACER Report 2010-11)

Figure 4.5: Choice of Investment by Years in Schooling

(Source: NACER Report 2010-11)

147

Figure 4.6: Choice of Investment by Asset Ownership Category

(Source: NACER Report 2010-11)

Figure 4.7: Choice of Investment by the Gender of Investment

(Source: NACER Report 2010-11)

148

Principal Findings

Households with higher levels of education tend to invest more.

Only 21.25 per cent of households prefer to invest in secondary markets.

Households with a higher level of education invest relatively more widely in this

option. It was found that 26 per cent of households with more than 15 years of

education prefer to invest in secondary markets.

Twenty eight per cent of businessmen and 21 per cent of white- collar workers

prefer to invest in secondary markets.

Households that own higher levels of fixed assets generally prefer to invest in

secondary markets.

More than 18 per cent of unmarried investors chose to invest in the complex

derivative market, which reflects their greater tendency for taking risks compared

to their married counterparts.

During periods of high inflation, bonds are the preferred option for households

with lower levels of assets as high interest rates are bound to lower bond prices.

Male investors invest more through IPOs than their female counterparts.

Households with a higher level of education prefer a longer time horizon for the

investment.

Households with higher incomes prefer to opt for investments of longer duration.

In case of windfall gains, households with low levels of assets engaged in risky

behavior (participated in the derivative market) compared to households that own

progressively higher levels of assets.

For those who wish to take advantage of the market, mutual funds are the most

preferred investment option. The survey reveals that 40.8 per cent of all

households invest in mutual funds, which constitutes the single largest allocation

compared to all other options.

Only 29 per cent of unmarried investors invest in mutual funds compared to 41 per

cent of married investors.

149

In the case of widows or widowers, windfall gains are translated into investment in

mutual funds.

4.3.1 Investor‟s Preference for Mutual Fund Organization

Earlier in 90s UTI is the most popular institution among all mutual funds. It has attracted

around 84% of the total savings mobilized by all the mutual funds. 82% of the total

investors are UTI unit holders (per scheme there are 7 lakh investors). This is probably

because it is the oldest institution and is in operation since 1964. Further it is more known

to customers and it also offers more attractive packages to the investor with tax benefits

and concessions. Among rest LIC mutual fund, SBI mutual fund and CANBANK mutual

fund are more popular than the rest.

Except UTI, SBI and CANBANK mutual fund, the remaining competitors in this field do

not seem to enjoy much brand power. The LIC mutual fund‘s brand image is not as good

as it should be because it is associated with LIC which has its monopoly in life insurance

business. Though its position is better than the other four.

Certain degree of non-compatibility between UTI and the new mutual funds arises

because of differences in the legal structure, investment practices and also because the

UTI is so much older. The number of holders of a mutual fund organization and its size

of fund is to some extent a function of its age. However the advantage of age quickly

wears out because most schemes in India have a limited duration of 5-8 years. When they

expire, their place would have to be taken up by offers of new schemes. But now

situation has changed private sector mutual funds dominated resource mobilisation.

The gross mobilisation of resources by all mutual funds during 2011-12 was at ₨ 68,

19,678 crore compared to ₨ 88, 59,515 crore during the previous year indicating a

decline of 23.0 percent over the previous year (Table 4.1). Redemption also declined by

23.2 percent to ₨ 68, 41,702 crore in 2011-12 from ₨89, 08,921 crore in 2010-11. The

mutual fund segment recorded a net outflow of ₨ 22,024 crore in 2011-12 as compared to

an outflow of ₨ 49,406 crore in 2010-11.

150

The assets under management by all mutual funds decreased by 0.8 percent to ₨5, 87,216

crore at the end of March 2012 from ₨5, 92,250 crore at the end of March 2011.

Table 4.1: Sector-wise Resource Mobilisation by Mutual Funds during 2011-12

(₨` crore)

Particulars

Private Sector MFs Public Sector MFs UTI MF Grand

Total Open-

ended

Close-

ended

Interv

al Total

Open-

ended

Close-

ended

Interv

al Total

Open-

ended

Close-

ended Interval Total

1 2 3 4 5 6 7 8 9 10 11 12 13 14

Mobilisation

of Funds

55,59,558 1,15,116 9,069 56,83,744 5,96,696 15,695 1,091 6,13,482 5,14,272 4,702 3,479 5,22,453 68,19,679

-

67,61,888 -1,12,255 -48,781 -69,22,924 -11,34,871 -13,976 -3,887 -11,52,733 -7,68,968 -2,643 -12,247 -7,84,176

-

88,59,515

Repurchase/

Redemption

55,67,914 1,13,318 17,957 56,99,189 6,01,662 13,926 1,289 6,16,877 5,15,947 4,829 4,861 5,25,637 68,41,702

-

68,48,705 -46,801 -46,634 -69,42,139 -11,56,064 -6,395 -3,830 -1,66,288 -7,84,176 -4,021 -12,296 -8,00,493

-

89,08,921

Net Inflow/

Outflow of

Funds

-8,356 1,799 -8,888 -15,446 -4,965 1,769 -198 -3,394 -1,675 -126 -1,382 -3,184 -22,024

(-86,816) -65,454 -2,147 (-19,215) (-21,193) -7,581 -57 (-13,555) (-15,209) (-1,377) (-50) (-16,636) (-49,406)

Note: Figures in parantheses indicate corresponding figures for 2010-11

(Source SEBI)

Private sector mutual funds dominated resource mobilisation efforts during 2011-12.

However, the net outflow was larger from private sector mutual funds compared to UTI

mutual fund and public sector mutual fund. Nonetheless, net outflows were smaller

compared to the previous financial year. The net outflow from private sector mutual

funds during 2011-12 at ₨ 15,446 crore as against a net outflow of ₨ 19,215 crore in

2010-11. UTI mutual fund recorded a net outflow of ₨ 3,184 crore in 2011-12 compared

to net outflow of ₨ 16,636 crore in 2010-11. Net outflows recorded by public sector

mutual funds in 2011-12 was ₨ 3,394 crore compared to ₨ 13,555 crore in the previous

year. While all the open-ended and interval schemes of mutual funds recorded net

outflows, the close-ended schemes of public and private sector mutual funds witnessed

net inflows during the financial year.

Gross mobilisation of resources under open-ended schemes during 2011-12 was ₨ 66,

70,526 crore, of which, about 83.4 percent was raised by the private sector mutual funds

151

followed by public sector funds (8.9 percent) and UTI mutual fund (7.7 percent).

Similarly, gross resources mobilised under close-ended schemes stood at ₨ 1,35,513

crore in 2011-12, of which private sector accounted for 84.9 percent followed by public

sector funds (11.6 percent) and UTI mutual fund (3.5 percent).

Table 4.2: Unit Holding Pattern of All Mutual Funds as on March 31, 2012

Category Percentage to Total Investors Percentage to Total Net Assets

1 2 3

Individuals 94.5

(97.0)

48.2

(23.4)

NRIs 1.9

(1.9)

6.0

(2.0)

FIIs 0.0

(0.0)

0.9

(1.8)

Corporates/Institutions/Others 3.6

(1.1)

44.9

(72.8)

Total 100.0 100.0

Note: Figures in parantheses indicate corresponding figures for 2010-11.(Source SEBI)

Table 4.3: Unit Holding Pattern of Private and Public Sector Mutual Funds as on March 31,

2012

Category Percentage to Total

Investors

Percentage to Total

Net Assets

1 2 3

1. Private Sector Mutual Funds 65.6 82.4

Individuals 63.2 39.0

NRIs 1.6 5.4

FIIs 0.0 1.0

Corporates/Institutions/Others 0.7 36.9

2. Public Sector Mutual Funds (including UTI

Mutual Fund)

34.4 17.6

152

Individuals 31.2 9.0

NRIs 0.3 0.6

FIIs 0.0 0.0

Corporates/Institutions/Others 2.9 8.0

Total (1+2) 100.0 100.0

The unit holding pattern of public and private sector mutual funds as on March 30, 2012

also shows the dominance of private sector mutual funds in the number of investor

accounts as well as share in net assets (Table 4.4). The private sector mutual funds had

65.6 percent of the total investors account compared to 34.4 percent in public sector. The

unit holding pattern of public and private sector mutual funds as on March 30, 2012

shows the dominance of private sector mutual funds in the number of investor accounts

as well as share in net assets (Table 2.49). The private sector mutual funds had 65.6

percent of the total investors account compared to 34.4 percent in public sector.

In general the various factors that influence the investors‘ choice of mutual fund

organization in India are seen to be the:

i. Investment performance

ii. General reputation of the organization

iii. Suitability of schemes for investment or need and

iv. Post-sale service given to the customers

Investment performance is largely a matter of subjective impression or popular belief

rather than objective comparison in the present Indian situation. In due course, objective

measures of investment performance would acquire greater importance as data becomes

available and as investors become more sophisticated. Nevertheless, the popular belief

about investment performance is an important factor influencing investors‘ choice in

India. The average Indian investor today attaches distinctly greater weight to capital

appreciation than to annual dividend. The general reputation of a mutual fund

organization is among the weightiest factor influencing investors‘ choice. In public sector

UTI is the most preferred one among the investors because of its goodwill and reputation.

It has been identified generally as safe and reliable. It enjoys wide trust of the investing

153

public. UTI units are treated as trustees‘ securities for investment of provident funds,

other trust funds etc..The quality of post-sale service given to clients and the

understanding of the needs of investor while designing investment schemes also play

some role in investors‘ choice. An average investor was found to place more reliance on a

friend‘s suggestion than on agents‘ recommendation. Agents role in the distribution and

collection of application forms for mutual fund schemes is quite vital in the overall

process of selling mutual fund schemes but his recommendations has less influence on

investors than other factors. Advertisement of scheme is relatively important.

4.3.2 Investor‟s Preference among Types of Mutual Fund Schemes

Till 2011-12, of different scheme floated by Indian Mutual funds, income /debt oriented

schemes were very popular. The average Indian was conservative and preferred

investment avenues which offer reasonable returns with lower risk. This was one of the

reasons why the new bank sponsored mutual funds started the practice of assuring

minimum returns in their schemes. At that time most of the household investors were not

willing to invest in mutual fund schemes unless there was a promise of minimum return

because they considered the schemes unsafe without such promise.

The share market boom of 1991-92 played an important role in changing the investor‘s

attitude. Investors having greater confidence in the mutual fund instruments and

displaying greater willingness to bear risk for higher returns. The share of pure growth

scheme increased substantially. The collapse of the stock market boom after April 1992

has curbed to some extent the investors‘ over enthusiasm generated for equity schemes

but not all gain seems to have been erased. Investors such as aged / retired person have a

strong preference for regular income schemes. They are also in demand by provident

fund, trust funds etc..

Taxes saving schemes are next in popularity to equity schemes. Such schemes offer a

deduction in income tax based on the amount invested in them. They are also wholly or

largely equity schemes. They are more popular among higher income classes than among

the lower income classes.

154

Today the tendency has changed amongst the mutual funds (especially the private sector

entrants)

Table 4.4: Scheme-wise Resource Mobilisation and Assets under Management by Mutual

Funds as on March 31, 2012

Schemes

No. of

Schemes

Gross

Funds

Mobilised

(₨ crore)

Repurchase/

Redemption

(₨ crore)

Net

Inflow/

Outflow

of

Funds

( ₨ crore)

Assets

Under

Management

as on March

31, 2011

(₨ crore)

Percentage

Variation

over

March

31, 2010

1 2 3 4 5 6 7

A. Income/ Debt Oriented Schemes

i) Liquid/ Money

Market

55 59,46,498 59,53,603 -7,104 80,354 9.1

ii) Gilt 42 4,050 4,070 -20 3,659 7.3

iii) Debt (other than

assured return)

775 8,03,565 8,22,094 -18,529 2,90,844 -0.4

Sub Total (i+ii+iii) 872 67,54,113 67,79,766 -25,653 3,74,857 1.6

B. Growth/ Equity Oriented Schemes

i)ELSS 49 2,698 2,841 -143 23,644 -7.5

ii) Others 303 47,921 47,657 264 158,432 -6.7

Sub Total (i+ii) 352 50,619 50,498 121 1,82,076 -6.8

C. Balanced Schemes

Balanced Schemes 30 5,027 4,645 382 16,261 -11.8

D. Exchange Traded Fund

i) Gold ETF 14 5,265 1,619 3,646 9,886 124.7

ii) Other ETFs 21 3,298 3,921 -623 1,607 -36.2

Sub Total (i+ii) 35 8,563 5,540 3,024 11,493 66.1

E. Fund of Funds Investing Overseas

Fund of Funds investing

overseas

20 1,356 1254 102 2,530 0.6

TOTAL(A+B+C+D+E) 1,309 68,19,679 68,41,702 -22,024 5,87,217 -0.9

Note: Net Assets of ₨ 6169.2 crore pertaining to Fund of Funds as on March 30, 2012 is not included in the above data.

155

The asset under management (AUM) of all the mutual funds is ₨5, 87,217 crore as on

March 31, 2012. The AUM was the highest for income/debt oriented schemes at₨ 3,

74,857 crore while the AUM under growth/equity oriented scheme was ₨ 1, 82,076 crore.

In terms of growth in AUM, Gold ETFs (124.7 percent) achieved the highest increase

followed by liquid/money market schemes (9.1 percent) and gilt schemes (7.3 percent)

during the year. Even though the net mobilisation was positive for growth /equity

oriented schemes their AUM declined by 6.8 percent during 2011-12. Same was the case

for balanced funds which faced a decline in AUM of 11.9 percent. The highest decline in

AUM was in the ETF category other than gold at 36.2 percent.

As on March 31, 2012, there were 1,309 mutual fund schemes of which, 872 were

income/debt oriented schemes, 352 were growth/equity oriented schemes and 30 were

balanced schemes (Table 4.5). In addition, there were 35 Exchange Traded Funds, of

which 14 were Gold ETFs and 21 other ETFs. Also, there were 20 schemes operating as

Fund of Funds which invested in overseas securities. Maturity-wise there were 745 open-

ended schemes and 530 close-ended schemes as on March 31, 2012. For the income/debt

oriented schemes category, the number of close-ended schemes exceeded open-ended

schemes. The mutual funds were one of the major investors in the debt segment of the

Indian securities market. During 2011-12, the combined net investments by the mutual

funds in debt and equity was ₨ 3, 33,463 crore compared to ₨ 2, 29,352 crore in 2010-11,

registering an increase of 45.4 percent (Table 4.4). Mutual Funds were net sellers in

equity segment with ₨ 1,357 crore, whereas, their net investments in the debt segment

rose to ₨ 3, 34,820 crore during the same period. The combined net investment was

positive for all months in 2011-12 except May 2011 and August 2011.

Table 4.5: Number of Schemes by Investment Objective as on March 31, 2011

Schemes Open-ended Close-ended Interval Total

1 2 3 4 5

A. Income / Debt Oriented Schemes

i) Liquid/Money Market 55 0 0 55

156

ii) Gilt

iii) Debt(other than assured return)

Sub Total ( i + ii +iii)

(51)

42

(37)

229

(210)

326

(298)

(0)

0

(0)

512

(346)

512

(346)

(0)

0

(0)

34

(35)

34

(35)

(51)

42

(37)

775

(591)

872

(679)

B. Growth / Equity Oriented Schemes

i) ELSS

ii) Others

Sub Total (i+ii)

36

(36)

299

(318)

335

(354)

13

(12)

4

(9)

17

(21)

0

0

0

(1)

0

(1)

49

(48)

303

(328)

352

(376)

C. Balanced Schemes

Balanced Schemes 29

(31)

1

(1)

0

0

30

(32)

D. Exchange Traded Funds

i) Gold ETF

ii) Other ETFs

Sub Total (i+ii)

14

(10)

21

(18)

35

(28)

0

(0)

0

(0)

0

(0)

0

(0)

0

(0)

0

(0)

14

(10)

21

(18)

35

(21)

E. Fund of Funds Investing Overseas

Fund of Funds Investing Overseas 20

(16)

0

(0)

0

(0)

20

(16)

TOTAL (A+B+C+D+E) 745

(727)

530

(368)

34

(36)

1,309

(1,131)

Note: Figures in the parentheses pertain to previous financial year.

Mutual funds are one of the several options that investors explore for investing surplus

funds. In a deposit-dominated market like India it is important for mutual funds to be able

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to offer differentiated risk-rewards and gain shelf-space. With many seemingly similar

offerings from multiple mutual funds unable to clearly communicate their superiority, a

less informed investor may find it difficult to make a choice. This uncertainty leads to a

weakened ‗pull‘ for the product. On the other hand, in an open architecture distribution

scenario, distributors are well aware of the differential incentive and brokerage structures

across products. After the compensation norms for distributors were altered (i.e. abolition

of entry load), the brokerage offered for selling mutual fund products has become less

competitive vis-àvis some other products. Thus, the ‗push‘ for the product has also

weakened.

Against this backdrop, the industry has seen the number of mutual funds grow from 32 to

46 over the last six years. The number of schemes has grown from 779 to 4,473 (counting

various options of a single scheme as separate schemes) in the same period. Further, there

have been 18 new entrants through the joint-venture (JV) or acquisition route, which

include the following:

Nomura

KBC Bank

L&T Finance

Goldman Sachs

Natixis Global AMC

T Rowe Price

Pramerica

There is one reported proposed entry – of Schroder Investment Management through the

acquisition of a significant minority stake in an existing AMC or trust company and also

one reported proposed exit, viz. Fidelity. This growth serves to demonstrate that, at a

fundamental level, there are many significant global and local players that consider the

Indian mutual fund industry to be attractive. It is necessary to understand the mix of

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investors, distributors, types and number of schemes as factors that contribute to a

sustainable and profitable operating model. The data as on 31 March 2012 relating to

geographic contributions to the total AUM tells a revealing story. The large number of

corporate investors contributing to the skew towards the debt oriented or non-equity AuM

is mirrored by the disproportionate contribution from Mumbai. The top five cities

(Mumbai, New Delhi, Bangalore, Kolkata and Chennai) contribute over 71% of the total

AUM, with Mumbai alone accounting for more than 42%.

Figure 4.8: AUM by geography as on 31 March 2012

(Source: AMFI data)

The statistical analysis throws up a few more facts:

• Over 43% of the AUM is from corporate investors.

• Over 90% of corporate investor funds are invested in non-equity schemes.

• Almost 85% of corporate investors keep their funds in schemes for less than 12 months.

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Figure 4.9: AUM mix by investor type as on 31 March 2012

(Source: AMFI data)

Figure 4.10: AUM Mix of investment by investor type as on 31 March, 2012

9.10% 13.30%

33.10%27.20%

83.80%

90.90% 86.70%

66.90%72.80%

16.20%

0%

20%

40%

60%

80%

100%

120%

Corporates Banks & Fis FIIs High net-worthindividuals

Retail

Equity Non-equity

(Source: AMFI data)

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Figure 4.11: AUM ageing of retail and corporate folios as on 31 March, 2012

(Source: AMFI data)

(Source: AMFI data)

Thus, an overwhelming majority of the funds garnered from the urban non-retail segment

are short-term investments. Further, this is not a short-term trend as it has been noticed

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over a period of a few years. Therefore, if the industry wants to change the age profile of

the funds it has at its disposal, it needs to seriously look at the other investors i.e. retail

investors and high net-worth individuals (HNIs) in the urban and semi-urban areas. This

will also help fulfill the objectives of financial inclusion. This is not to say that corporate

investors should not be encouraged to invest in mutual funds as this leads to channelizing

corporate surpluses into the capital market in a structured fashion. At the same time

AMCs could do well to have a sharper focus on the retail investor.

It is good to remember that mutual funds originally aimed to provide individual investors

with the opportunity to make long term capital market investments. Earlier, ‗long-term‘

referred to periods of five to ten years. The perception in recent times of long-term is

probably that of two to three years. This is a period not nearly enough for a fund manager

to demonstrate an alpha that justifies continued investment.

4.4 IMPACT OF MUTUAL FUNDS‟ GROWTH ON FINANCIAL MARKET AND

ITS COMPONENT

Financial sector development can be viewed as a process that enhances four critical

attributes of the financial system: efficiency, stability, transparency and inclusion. The

emergence of intermediation mechanisms and products that help improve on one or more

of these without causing others to weaken are, therefore, a meaningful indicator of

financial development.

From this perspective, Mutual Funds play an important role in the development of the

financial system. First, they pool the resources of small investors together, increasing

their participation in financial markets, which helps both inclusion and the efficient

functioning of markets themselves, as a result of larger volumes.

Second, Mutual Funds, being institutional investors, can invest in market analysis

generally not available or accessible to individual investors, thereby providing services

based on informed decisions to small investors. Decisions made on the basis of deeper

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understanding of risks and returns contribute to financial stability, besides helping to

mitigate market risk for this group of investors.

Third, transparency in investment strategies and outcomes, though typically mandated by

regulators, is relatively easy to deliver on, so that investors can find out exactly where

they stand with regard to their investments at any point of time.

As far as regulation is concerned, Mutual Funds cut across domains. The Reserve Bank

of India regulates three categories of financial markets; money markets, government

securities markets and foreign exchange markets. Mutual Funds have a presence in the

first two and the Reserve Bank is therefore interested in the role that they play in

developing them. In what follows, I shall provide a brief description of the role of Mutual

Funds in these two critical markets and discuss some of the regulatory issues that arise. I

shall then make some more general comments about the role of Mutual Funds in financial

inclusion.

Mutual Funds have contributed significantly in broadening and deepening of different

segments of the Money Market and, to some extent, the Government Securities market.

Money Market Mutual Funds (MMMFs) were introduced in India in April 1991 to

provide an additional short term investment avenue to investors and to bring money

market instruments within the reach of individuals.

The guidelines for MMMFs were announced by the Reserve Bank in April 1992. The

Reserve Bank had made several modifications in the scheme to make it more flexible and

attractive to banks and financial institutions. These guidelines were subsequently

incorporated into the revised SEBI regulations. In October 1997, MMMFs were

permitted to invest in rated corporate bonds and debentures with a residual maturity of up

to one year, within the ceiling existing for Commercial Paper (CPs). The minimum lock-

in period was also reduced gradually to 15 days, making the scheme more attractive to

investors.

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MMMFs have witnessed phenomenal growth over the period. As on May 31, 2011, the

total assets under management of the MMMFs was placed at ₨1, 83,622 crore, 25 per

cent of the aggregate assets under management of the Mutual Funds.

In order to promote retail holding in government securities and broaden the investor base,

Mutual Funds which invest exclusively in government securities, Gilt Funds, were

introduced. The first Gilt Fund in India was set up in December 1998. However, Gilt

Funds have registered moderate growth. As on May 31, 2011, the total asset under

management of the Gilt Funds was placed at ₨3,336 crore, 0.5 per cent of the aggregate

assets under management of the Mutual Funds.

Mutual Funds occupy a large share of the primary market of Certificates of Deposit

(CDs) and CPs. As on June 10, 2011, the total holdings of Mutual Funds in CDs and CPs

remained at ₨2, 95,164 crore (66 per cent of the aggregate outstanding) and ₨82,951

crore (65 per cent of the aggregate outstanding) respectively. Mutual Funds have also

provided substantial liquidity to the secondary market segments of CPs and CDs. Their

increased activity in the secondary market corresponds to their growing portfolio of

money market investments. During the last six months, MFs' share in the daily turnover

the secondary market of CDs and CPs stood at around 41 per cent and 46 per cent

respectively.

The overnight segment of the money market has also benefitted from the participation of

Mutual Funds. Their reliance on the collateralized segment of the overnight markets, viz.

market repo and Collateralized Borrowing and Lending Operations (CBLO), for

placement of their daily surplus liquidity enhanced the depth of the markets.

By contrast, in the Government Securities market, the participation of Mutual Funds has

not been very encouraging. Of the outstanding Government of India dated securities, the

Mutual Funds held 0.9 per cent as at end December 2010, which dropped to 0.2 per cent

as at end March 2011. The average holding of government securities by the Mutual

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Funds during the last two years remained at 0.6 per cent as against 38.7 per cent by the

banks, 22.4 per cent by insurance companies, 8.9 per cent by PDs, 6.7 per cent by PFs,

3.1 per cent by corporate entities. During the year 2011 till end of May, the average share

of Mutual Funds in the secondary G-Sec market remained at 5.8 per cent of the total

traded volume. One possible reason for the lower level of participation of Mutual Funds

in the G-Sec market is lack of investor interest in the gilt-oriented Mutual Funds due to

significant interest rate risks.

There is a need for Mutual Funds, especially gilt funds, to complement the role of PDs in

promoting retail holding in government securities. Mutual Funds are supposed to tap

retail investors, who in turn, to the extent that they have long horizons, provide stability

to the market. They also benefit small investors by providing them access to risk-free gilt

edged securities.

The Mutual funds are allowed to participate in the Interest Rate Swap (IRS) market for

the purpose of hedging their own balance sheet risks. However, their participation has

remained quite muted. The IRS market, although very liquid, suffers from a low customer

base of around 1 per cent. The Mutual Funds may increase the use of IRS for hedging

their interest rate risk which would help in broadening and deepening of the IRS market.

Mutual Funds are also allowed by SEBI to trade on Interest Rate Futures (IRF). IRF

contracts on 10-year notional coupon bonds were launched on NSE in August 2009. The

product witnessed significant activity during the initial period, but liquidity tapered off

subsequently. RBI has already issued guidelines for futures contracts on 91-day T-Bills,

which are expected to be introduced shortly. RBI is also considering introduction of IRF

contracts on 2- year and 5-year G-Secs. If the reason for Mutual Funds not actively

participating in the G-Sec market is the underlying interest rate risk, then they obviously

should make use of the IRF to hedge their interest rate risk. Their active participation will

give impetus to the development of the IRF market.

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The launch of Credit Default Swap (CDS) is impending. The guidelines on introduction

of plain vanilla OTC single-name CDS for corporate bonds in India would be effective

from October 24, 2011. The Mutual Funds would be eligible to buy credit protection (buy

CDS contracts) to hedge their underlying credit risk on corporate bonds. They would also

be permitted as market-makers subject to their having strong financials and risk

management capabilities as prescribed by SEBI and as and when permitted by the SEBI.

It is expected that Mutual Funds‘ participation will provide momentum to the CDS

market.

A significant feature of MMMFs or liquid Mutual Funds in India is that they have been

mainly catering to the short-term investment needs of institutional investors such as

corporate and banks whose redemption requirements are large and simultaneous. As on

March 31, 2011, the investor profile of liquid funds was dominated by corporate (76.5

per cent) followed by Banks/FIs (17.1 per cent), HNIs (5.3 per cent). As a consequence,

when the banking sector faces liquidity shortfall and withdraws its investment from liquid

Mutual Funds, they collectively come under stress. This may lead to a sharp fall in banks‘

fresh investment in liquid funds which, in turn, could intensify the pressure on those

entities that receive investments from the liquid funds.

It may be recalled that during October-November 2008, RBI had to provide a special

dispensation in the form of Term Repo facility of ₨60,000 crores, under which banks

could avail central bank funds to address the liquidity stress faced by Mutual Funds,

NBFCs, HFCs. Banks were given an SLR exemption up to 1.5 per cent of NDTL to

address this problem.

A related issue is the circularity of funds between the banking system and Mutual Funds.

Banks invest in Mutual Funds and the Mutual Funds put large volume of funds back to

the banking system through investments in CDs, lending in CBLO and Market Repos.

Such circular flow of funds between banks and Mutual Funds has the potential for

creating systemic instability in times of stress/liquidity crunch. Thus, banks could

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potentially face a large liquidity risk. In this connection, RBI had announced in the

monetary policy on May 3, 2011 that the bank‘s investment in debt oriented Mutual

Funds to be capped at 10 per cent of net-worth as on March 31 of the previous year and

banks would be given a period of six months to achieve this limit.

From a prudential perspective, there is the possibility of banks‘ investments in the Mutual

Funds getting channelized to sensitive sectors such as real estate and stocks. This may

lead to banks‘ exposure to such sensitive sectors going beyond the prescribed prudential

limits.

The role of Mutual Funds in promoting savings continues to be insignificant in India.

Despite a long history, assets of Mutual Funds in India constitute less than 10 per cent of

GDP. A cross-country comparison suggests that Mutual Funds are very popular all over

the world. However, assets under them in India are relatively low as compared with other

emerging market economies.

One of the major reasons for relatively low activity of Mutual Funds in India is that

penetration, especially in the rural areas remains small. This is an important issue from

the perspective of financial inclusion of low-income households in the formal financial

system. It is generally perceived that Mutual Funds are popular mainly with the middle

and high-income groups and have not been found to be an attractive investment avenue

for the low-income groups. Thus, if the sector has to grow fast, it needs to devise

appropriate schemes to attract the saving of low-income groups, especially in rural areas.

This is the only way to ensure participation of all categories of investors in the financial

markets, which is crucial for sustained development, both of the financial sector and the

economy as a whole.

Mutual Funds clearly have a significant role to play in financial development. Their

modus operandi of aggregating pools of saving from a large number of retail investors

and deploying these resources in a variety of financial markets, based on different risk-

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return preferences simultaneously enhances efficiency, stability and inclusion. It is also

relatively easy for them to be transparent about both their strategies and outcomes.

This, of course, is a statement of ideal conditions. In the real world, there are clearly

barriers to achieving these objectives. Some of these have to do with penetration, others

with the preferences of investors, particularly with respect to duration, some more with

legitimate regulatory concerns about systemic risk and yet others with gaps or imbalances

in the broader regulatory framework. However, if there is broad agreement that

appropriately regulated mutual fund activity can play a large part in financial

development in all its dimensions, these barriers can surely be addressed in a

collaborative way between the three stakeholders – the investors, the fund managers and

the regulators.