Growth in Mutual Fund AUM - Reasons, Implications & Suggestions

Growth in Mutual Fund AUM - Reasons, Implications & Suggestions

Over the past few years, India's Mutual Funds (MFs) have seen strong growth in assets under management (AUM). 

MF AUM has grown from INR 9.4T in April 2014 to INR 21.4T in October 2017, at a compounded annual growth rate (CAGR) of 26%. In contrast, during the period April 2010 to April 2014, MF AUM growth was a sedate 5% CAGR.  

Within this, equity MF AUM has grown fourfold from INR 1.9T in April 2014 to over INR 8T now. As a result, the proportion of equity in MF AUM has grown from 21% in April 2014 to 38% now.

Possible reasons for this growth

What explains this rapid growth in MF AUM, and particularly equity MF AUM? 

One likely reason is that term deposit rates have moved down substantially since 2014, in tandem with the RBI easing cycle. In addition, interest income from bank fixed deposits is taxable with no inflation indexation benefit, while Mutual Fund investments still have substantial tax benefits. The graph of SBI’s 5y fixed deposit rate alongside total India MF AUM is appended below in Fig. 1.

The shaded portion to the right highlights reducing fixed deposit rates, alongside the sharp increase in MF AUM, since early 2014. At 6% from 1st November 2017, the post-tax return on a 5y deposit with SBI is around 4% per annum. 

Within mutual funds, the 2014 Union Budget reduced the attractiveness of debt mutual funds by making them eligible for long-term capital gains with inflation indexation only after 3 years, as opposed to 1 year earlier. In contrast, equity funds still offer the benefit of long-term capital gains tax after a period of 1 year. 

In part backed by this wall of liquidity, BSE SENSEX has given attractive, tax-friendly returns of 12% CAGR since April 2014, and 25% this year alone. Contrast this to the reducing yields from incremental debt savings. 

With lower thresholds of return from debt savings, the history of superior returns from equity investments, and clear tax benefits, it is easier to market equity as a class for financial savings, particularly through a programmed approach like systematic investment plans (SIP). 

In addition, equity funds offer higher annual fees to the AMC (around 1.5% of AUM) and to the intermediary (about 0.5%-0.75% of AUM), compared to debt savings. Wealth advisors - including in banks - would benefit more from selling equity mutual funds rather than debt. 

Implications & Recommendations

There are several implications of these trends, which are worth debating.

First, is this trend in MF AUM growth desirable? Financial experts would argue it is, given that MF AUM helps channel savings into debt and equity capital markets. This in turn helps ease the burden on banks in financing long-term investments. The size of outstanding corporate bonds has grown from INR 14.7T in March 2014 to INR 25.9T in September 2017. We have had several equity IPOs and FPOs this year, and more are forthcoming.

However, the sheer pace of this growth does call for caution. It is unclear if our capital markets have the capacity to absorb additional funds at this pace, without risks of financial instability. At the moment at least, much of the additional savings into equity MF AUM appear to be translating into valuation gains and wealth monetization through IPO for a few, rather than funding fresh real investments. 

Likewise, on the debt side, a major part of recent corporate bond issuances is relatively short-term fund-raising by non-banking finance companies (NBFCs), rather than any funding for fresh, real, long-term investments.

Admittedly, it is difficult to argue that debt and equity valuations are excessive - after all, who knows. However, one can and must look at the reasons for the growth in AUM, and to the extent the growth is based on preferential incentives, these must be reviewed.  

Alongside, our market infrastructure needs to be strengthened. With increased savings into debt MF AUM, corporate bond end-of-day valuation processes need to be improved. Regulators may need to pay as much attention to NBFC balance sheets, as banks. Additionally, across debt and equity markets, there is a need to reinforce strict suitability and appropriateness standards while selling financial products to clients. 

Second, from a banking perspective, there has been a substantial leakage of term deposits to mutual funds and NBFCs. The funds do come back into the banking system, but as short-term liabilities, rather than term deposits. Whatever the desired end-state, as of now, banks still do the heavy lifting of funding industry and investments. Bank loans, at INR 80T, is over three times the total corporate bond outstanding of INR 26T. Leaving banks short of long-term deposits is not good news for financial stability or for the growth of the economy.

This is not apparent today, when banks are flush with short-term liquidity. But when the investment cycle restarts, and when Basel liquidity standards including net stable funding ratio (NSFR) come into play, this will start to pinch. 

The incentive for long-term savings away from banks needs to be reconsidered. Interest income on bank deposits over three-year maturity perhaps deserves the same tax benefits of indexation as debt mutual funds. We also likely need a steeper yield curve, so that long-term savers see adequate returns from fixed deposits and debt funds, rather than only from riskier equity. Long-term debt savings is as much needed to fund infrastructure investments, as is equity. 

Third, this also has implications for our monetary policy. Since 2014, CPI inflation has been under control, thanks to lower international oil prices and controlled food prices. This in turn has allowed our CPI-repo rate centric monetary policy to reduce policy repo rate by 200 bps.

The current rapid growth in MF AUM and the growth in equity asset prices may at least partially be a result of this monetary policy. This presents a dilemma for policymakers. Can and should they make the argument that excessive equity market inflation can eventually drive CPI up, and therefore call for a cautious monetary response today? There are multiple other factors that could impact financial stability - the current low capacity utilization, banking and corporate balance sheet health, tepid private investments, uncertain employment trends, the external sector, etc. Can and should the monetary policy committee (MPC) impute an impact on CPI from each of these factors? Or should they target financial stability directly, rather than loop back every metric - sometimes in a very artificial manner - to an eventual impact on CPI inflation? 

Likewise, perhaps there is a case for monetary policy to consider tools besides just a blunt policy repo rate. For instance, one approach could be targeting the shape of the yield curve rather than just a single rate. With low capacity utilization, USDINR and balance sheet stress arguably calling for lower short-term interest rates, and equity asset prices, global uncertainties and fiscal uncertainty arguably calling for higher long-term interest rates, a steeper yield curve may be an optimal response.

Additionally, the use of macro-prudential measures for targeting financial stability should also be considered alongside interest rates. In the past, RBI has used punitive risk weights to control excessive flow of funds to certain sectors. More controversially, RBI could also consider helping channel the flow of funds into desirable areas of investment, such as education, water table and irrigation management etc. Given 40% of banking loans are anyway directed under RBI's priority sector lending (PSL) norms, perhaps there is room to include investments within PSL that can improve infrastructure, supply, employment and help reduce inflation.