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Chapter I

Introduction

The goal of getting higher returns has always persuaded mankind to develop

more and more avenues of investments. The establishment of the company form of

organization and the subsequent trading in their shares and derivatives based on them

are all an effort in this direction. One of the financial innovations which really helped

the small investors to earn wealth is the concept and design of mutual funds. No

longer is it felt that the share or commodity trading is reserved for rich and elite. Any

investor now big or small, retail or non retail can now participate and play his bets on

virtually any asset through the use of mutual funds.

This chapter describes the history and the concept of mutual fund. It also

discusses the important advantages, disadvantages and most commonly used

classification of mutual funds. Mutual fund industry at the global level, in United

States (largest mutual fund market) and in India is suitably discussed. Structure,

marketing and distribution of mutual funds in India is also discussed in relevant

sections. Lastly, this chapter discusses rationale for the present study and finally

concludes on listing of the objectives for the study. Accordingly the chapter is divided

into following sections.

1.1 History of Mutual Fund

1.2 Definition and Concept of Mutual Fund

1.3 Advantages and Disadvantages of Mutual Funds

1.4 Global Mutual Fund Industry

1.4.1 World Mutual Fund Industry

1.4.2 United States Mutual Fund Industry

1.4.3 Mutual fund industry in other Regions

1.5 Indian Mutual Fund Industry

1.5.1 History of Mutual Funds in India

1.5.2 Structure of Mutual Funds in India

1.5.3 Growth of Mutual Funds in India

1.5.4 Classification of Mutual Funds

1.5.5 Distribution and Marketing of Mutual Funds in India

1.5.6 Future prospects of Mutual funds in India

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1.6 Rationale of the study

1.7 Objectives of the study

1.8 Organisation of the study

1.1 History of Mutual Funds

Tripathy (2004b) observed that history of mutual funds dates back to the times

when Egyptians and Phoenicians were selling shares in vessels and caravans to

mitigate the risk of these instruments. Modern day concept of mutual fund has its

origins in the establishment of Societe General de Belgique in 1822, Foreign and

Colonial Government Trust of London in 1868 and Scottish American Trust in 1873

(p. 46). The author also observed that mutual fund industry traveled from Great

Britain and France to United States. Rouwenhorst (2004) noted that investment trusts

had been in existence in Holland for almost a century, before the trusts were formed

in United Kingdom in mid 19th century. First trust by the name of Eendragt Maakt

Magt (meaning Unity Creates Strength) was formed in 1774 by Dutch Merchant and

broker Adriaan van Ketwich, following the financial crises of 1772-73. Anderson and

Ahmed (2005) noted that some financial historians linked development of mutual

funds to the Massachusetts Hospital Life Insurance Company formed in 1823 which

accepted and pooled funds to invest on behalf of its contributors.

Haslem (2003) highlighted the history of mutual fund in United States. Boston

Personal Property trust was the first close ended American Investment Trust formed

in 1893 and by 1920 close ended investment trusts were very high in number. The

creation of Alexander Fund in Philadelphia, Pennsylvania in 1907 was an important

step in creation of modern day mutual funds. There was the provision of semi annual

issues in Alexander Fund, which made the withdrawal easier for the investors. The

first truly open ended mutual fund was Massachusetts Investment Trust (MIT) formed

in Boston in 1924 followed by the formation of State Street Investment Trust in 1924

and First Investment Counsel Trust in 1928 (it was organized as first no load fund).

MIT introduced the mutual fund’s defining attribute – the continuous offering and

redemption of units or shares at Net Asset Value, which later became the global

standard for open ended funds. Great stock market crash of 1929 marred the growth

of close ended investment trusts, leading to stringent regulations and formation of

Securities and Exchange Commission (SEC) in 1934. It was SEC which bought out

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Investment Companies Act of 1940 that provided set of rules and regulations for

establishment of mutual funds in America. From 1940 to 1970, very stable growth

was observed in mutual fund industry in United States. It was only after 1970s;

mutual fund industry saw tremendous growth not only in United States, but also

around the globe and growth was especially observed in open ended schemes.

Zweig (1999a, 1999b) outlined and discussed the growth of mutual funds. He

noticed that money market mutual funds were introduced in 1971, which later on

bought dramatic growth in the US mutual fund industry. The first money market fund

(The Reserve Fund) provided handsome returns to the investors, who had discovered

the significant innovation in the form of money market fund. In 1974, Fidelity daily

income trust became first to offer the facility of cheque writing on fund investments.

In 1976, first retail index mutual fund was introduced by the name of First Index

Investment Trust (now known as Vanguard 500 Index Fund – one of the largest index

funds globally). Index funds later on became so common that at present significant

share of global mutual fund assets has been constituted by the index funds.

In short although mutual fund like instruments were present even as early as

mid 18th century yet according to most of the financial historians the history of mutual

fund dates back to mid of the 19th century, which originated in United Kingdom and

later spread to United States. Massachusetts Investment Trust really marked the

beginning of modern day concept of mutual fund. It was only after 1970 that the

global financial scene witnessed the dramatic proliferation of types and assets of

mutual funds.

1.2 Definition and Concept of Mutual Fund

According to Anjaria and Anjaria (2001) a mutual fund is a common pool of

money into which investors place their contributions that are to be invested according

to the stated objective. The ownership of fund is thus ‘mutual’; that is the fund

belongs to all the investors. A single investor’s ownership of the fund is in same

proportion as the amount of the contribution made by him or her bears to the total

amount of fund.

According to the Securities and Exchange Board of India mutual fund is

defined as ‘A fund established in the form of a trust to raise monies through the sale

of units to the public or a section of the public under one or more schemes for

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investing in securities, including money market instruments or gold or gold related

instruments (Taxmann SEBI Manual Vol 2, 2008, p. 4.729).

Mutual fund buys the assets by combining the money of its investors

according to its stated objectives. For example the equity funds will buy only equity

or equity related products or according to the mix as is stated by its investment

objective. When an investor buys the fund, he actually buys the proportion of the fund

and therefore he becomes the holder of the proportion of the underlying assets, in the

same proportion as his investment is. In US, mutual fund is constituted as an

‘Investment company’ and the fund holder actually buys the shares of the investment

company or the fund. In India mutual fund is constituted as Trust and the investor

buys the units of the trust, therefore in India the shares of the fund are called units.

Further each unit is assigned a value, on which investor can buy or sell after adjusting

for the loads if any. Such a value is known as Net Asset Value and is calculated after

dividing all the assets of the fund minus liabilities by the outstanding units. Therefore

the total value of the mutual fund holding of the investor is equal to NAV per share

multiplied by the units he is possessing.

Mutual funds mobilize the savings of the investors and bring them to the

capital market. Because the persons running them are assumed to be knowledgeable

and informed, they generally influence the stock market and play an active role in

promoting good corporate governance, investor protection and health of capital

markets (Anjaria & Anjaria, 2001).

The European Union has adopted a common definition of UCITS or

“Undertakings for Collective Investment in Transferable Securities” commonly

interpreted as mutual funds. Across the world, organizations have identified schemes

similar to mutual funds like UCITS or Collective Investment Schemes (CIS). For

example the International Organization of Securities Commission (IOSCO) defines

CIS as an open ended collective investment scheme that issues redeemable units and

invests primarily in transferable securities or money market instruments (Khorana et

al, 2005).

1.3 Advantages and Disadvantages of Mutual fund

The origin of the mutual fund lies in the complexity of the capital markets. As

the markets and the various investment products it offers start getting more varied and

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complex, investors needed some kind of professional financial intermediary which

can provide the required knowledge and expertise on successful investing. More over

the landmark research on benefits of having a diversified portfolio by Markowitz

(1959) and several others later lead the investors to think in terms of forming a

diversified portfolio to achieve better risk adjusted returns. Building a diversified

portfolio requires systematic approach, thought, knowledge of the various sectors and

markets and above all the money to buy large number of stocks. Naturally the virtues

of professional portfolio management and building a diversified portfolio are beyond

the means of most of the individual investors. This complexity gave birth to mutual

fund. So the original advantages of mutual fund lie in providing diversification and

professional expertise to the investors.

An investor in mutual fund acquires a diversified portfolio and academic

research has shown (for example Evans & Archer, 1968) that diversification reduces

the risk of loss. The fund investor also reduces risk in another way. While investing in

a pool of funds along with the other investor, any significant loss on one or two

securities is also shared by the other investors. Same happens with the transaction

cost, when buying through the mutual fund, investor gets the benefit of economies of

scale (Haslem, 2003) as funds pay lesser cost because of large volumes and it passes

on the benefits to the investors.

Liquidity becomes a major concern when the investor directly invests in the

stock market. On the contrary this is one of the most important benefits of the

investing through mutual funds. Mutual funds provide standing liquidity especially in

relation to open ended funds. The fund houses themselves buy and sell the units to the

mutual fund account holders and in general they always honor their purchases and

redemptions.

Investment in mutual funds is very convenient and flexible. There are several

modes of investing in funds like investing through agents, financial advisors, brokers,

banks etc. Investors can also directly submit the applications in the AMC office.

Moreover investors can invest amount as little as Rs 100/- (micro SIPs have also been

introduced by some fund houses to take care of lower strata of the investor population

especially in rural areas) and participate in investments of equity and debt, thereby

providing a low cost and affordable way to invest in capital markets (Adjania, 2007).

Now a days Indian mutual fund industry also offers investing through conveniences of

products or facilities like Systematic Investment plans (SIP) and Systematic transfer

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plans (STP). SIP or dollar cost averaging as known in the western world is a very

convenient way of investing little fixed amounts in the mutual fund, which helps in

building up a big corpus down the years. Systematic transfer plan is another

convenience by which investors can park off their excess funds in some liquid or

money market or income fund and systematically transfer some fixed amount, or

dividend or capital appreciation to the equity mutual fund scheme.

It is only with the help of mutual funds, investors can conveniently buy and at

lower cost complex products like equity and bond indexes, commodity stocks,

hedging instruments, arbitrage products, thematic schemes, sectoral stocks,

international equity offerings, corporate and government bonds and money market

products. Directly getting these products are beyond the means of an ordinary

investor. Various products and their variants serve another purpose of meeting

investor objectives as different investors have different objectives of investing; shaped

up by their varied risk return profiles.

Worldwide mutual funds are well regulated and have to strictly adhere to

numerous compliances. Stricter regulation creates security in the minds of investors,

who with greater confidence invest and fully participate in the growth of capital

markets and economy. Compliances also lead to transparency and mutual funds are

required to disclose all their portfolio holdings (although with a lag); return

performance; fund manager details; expense details and all other pertinent information

for the use by the investor.

Tax rebates and incentives provided by the government to the mutual funds

also acts as an advantage. For example Indian Income tax law provides rebate on

investments made in notified mutual fund schemes (also known as Equity linked

saving schemes or ELSS). Any ELSS investor gets the rebate up to the maximum

amount of rupees one lakh in a financial year as per section 80C of the Income tax act

(Pathak, 2008, p. 613).

Services provided by mutual fund are another advantage to the mutual fund

investors. Gamut of services are provided by mutual fund houses like transparent and

full disclosure in account statement; full account statements on demand; daily

disclosure of NAV; periodic (generally monthly) disclosure of portfolio holdings; call

centre and toll number services; assessing the account information on internet; simple

application form etc.

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Notwithstanding advantages, there are also few disadvantages of investing in

mutual funds. No doubt mutual funds provide advantage of diversification but the

diversified portfolio in any particular mutual fund is common to all investors, and is

not customized for any particular investor. Individual investors have their own set of

risk return profiles and utility functions which may not well addressed by common

pool of investments like mutual funds. This disadvantage has been well addressed by

the asset management companies as they often have families of schemes which suit to

different investment objectives and profiles.

There is no control of investors on the costs incurred by the mutual fund. All

investors have to pay the costs in terms of expense adjustments in NAV, and it

doesn’t matter whether the investor is having one day old account or 10 year old

account. Fees are usually payable as a percentage of the value of his investments,

whether the fund value is rising or declining. A mutual fund investor also pays

distribution and marketing costs, which he would not be incurring in direct

investment.

Although open ended funds provide ample liquidity in terms of daily purchase

and redemption of units at daily NAVs, yet investors are unable to take advantages of

intra day market fluctuations, especially in the case of equity markets. Although

Exchange traded funds or ETFs have solved this problem to some extent.

1.4 Global Mutual Fund Industry

1.4.1 World Mutual Fund Industry

Most of the research studies on mutual funds have been concentrated on US

mutual fund industry. However some authors like Otten and Schweitzer (2002)

compared US and European mutual fund industry and found that European mutual

fund investors have a strong liking for fixed income mutual fund products as

compared to Americans who like equity funds.

Fernando et al (2003) lucidly explained the development of mutual funds

around the world. In the panel study of 40 developed and developing countries around

the world, on the basis of data from 1992-98, authors highlighted and explained the

development of mutual fund industry across the world. It was found that equity funds

comprised major share of the total fund assets in Hong Kong, South Africa, Sweden,

Switzerland and the United Kingdom. Bond funds were highly developed in Brazil,

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Hungary, Thailand and Tunisia. Money market funds had the largest share of fund

sector in Argentina, Chile, France and Greece. Balanced funds were most

predominant in Czech Republic, India, New Zealand and Poland. Non household

investors formed a significant share of assets in mutual fund industry in Brazil, France

and United States. There was a strong presence of non resident investors in

Luxembourg, Hong Kong, Ireland, Singapore and Switzerland. Explaining the

variation in the size of mutual fund industry authors found that fund industry is in

positive relation with the better developed capital markets, market based financial

systems, higher market returns, higher liquidity, lower political or country risk and

lower volatility. In high income countries openness to trade and high share of high

tech exports are positive significant factors while in low income countries per capita

income and strong banking systems are positive significant factors related to the size

of mutual fund industry. Equity funds have been found to be more advanced in

common law countries while bond funds have been found to be more developed in

civil law systems countries. Bond and money market mutual funds have significantly

developed in countries which have restrictions on competing products like limits on

bank interest rates (for example in United States and France). Authors also observed

that in developed countries investors are more concerned with market microstructure

and in comparison macro economic factors are most important in reference to

development of mutual fund industry in developing countries. The authors concluded

by citing that tremendous global growth of mutual funds may be attributed to

increasing financial globalization; expanding presence of large multinational financial

groups in large number of countries; equity and bond markets strong performance;

demographic ageing and investors search for safe, liquid and long term high return

instruments.

In another very extensive study, Khorana et al (2005) conducted a cross

sectional analysis of 55 countries having mutual fund industry in 2001. Authors found

substantial cross country variation in the sample with respect to development of the

fund industry. Four groups of explanatory variables namely legal, regulatory, demand

and supply side variables were used to explain the variation observed in the

development of fund industry. Authors observed that strong legal and regulatory

forces, especially stringent fund industry regulations have positive impact on fund

industry size, except in some cases. More specifically in the equity industry, failure to

enforce insider trading laws has a positive effect on fund industry size. With regard to

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supply side variables, when the restrictions have been applied on the banking industry

especially with regard to entry in the securities business, fund industry size gets

limited. More the cost and time it took to set up the fund, less was the fund industry

size. On demand side variables, it has been found that investor wealth measured in

terms of Gross Domestic Product (GDP) per capita and education has a positive

impact on fund industry size and this effect was more pronounced in equity fund

sector. In addition author also noted that the fund sector was larger in countries where

a greater proportion of pension funds were of defined contributions type.

Table 1.1 reflects the state of World mutual fund industry as of year end 2008.

The total world wide assets of mutual fund industry stood at 18974521 millions of US

dollars (hereafter USD) as of year end 2008. The world wide mutual fund assets had

been growing at the rate (compounded average growth rate or CAGR) of 7.21 percent

from year end 2001 to year end 2008. World mutual fund industry is constituted by

four regions, where American region (comprising United States and other countries)

is the largest region as it contributed 55.76 percent of world’s mutual fund assets

followed by Europe (33.14%), Asia and Pacific (10.74%) and African (0.37%) region

as of year end 2008. Together both American and European Region constitute

approximately 90 percent of world’s mutual fund assets which strongly signifies the

predominance of developed countries in mutual fund industry. On the other side,

African region had been the fastest growing region at the rate of 25 percent CAGR

from 2001 to 2008, although on a small base, followed by Europe (CAGR 10.29%),

Asia and Pacific (CAGR 10.10%) and America the slowest growing at the CAGR of

5.17% (Investment Company Institute [ICI], 2009).

With reference to countries, United States of America (USA) had the largest

share as it contributes to approximately half (50.60%) of world’s mutual fund assets

as of year end 2008. US was followed by two countries in European region namely

Luxembourg (9.81% share) and France (8.39% share) (ICI, 2009). The case of small

country of Luxembourg standing second in terms of largest market share in world’s

mutual fund assets is a special and curious case. As an explanation provided by

Khorana et al (2005) and Fernando et al (2003), favorable banking and tax laws have

led to the transformation of Luxembourg into a major centre for offshore mutual

funds.

The fastest growing countries in terms of growth in mutual fund assets in

American Region were Chile (CAGR 19.38%) followed by Brazil (CAGR 18.26%)

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and Mexico (CAGR 9.64%). In European region the fastest growing countries were

Romania (CAGR 64.50%), Russia (CAGR 31.56%) and Slovakia (CAGR 29.34%),

although all three have been showing growth on very small base. In Asian regions the

fastest growing countries were Hong Kong (CAGR 29.93%) followed by Philippines

(CAGR 29.13%) and India (CAGR 22.37%). African region is constituted by only

one country of South Africa growing at CAGR of 25 percent (ICI, 2009). Some

countries namely Costa Rica (CAGR -5.04%) in American Region; Greece (CAGR -

9.16%), Italy (CAGR -4.35%), Portugal (CAGR -2.24%), Slovenia (CAGR -8.78%)

in European Region; China (CAGR -36.34%), Pakistan (CAGR -4.23%) and Taiwan

(CAGR -1.08%) in Asian region had been showing negative rate of growth over 2001

to 2008 year end (ICI, 2009).

Table 1.2 reflects the growth in number of mutual fund schemes world wide.

The total number of mutual fund schemes in the global mutual fund industry stood at

69032 at year end 2008. Number of mutual fund schemes was much more in

European region (53.28%) as compared to American region (23.84%). Very close to

America is Asia and Pacific Region which constituted 21.60 percent towards number

of mutual fund schemes in global mutual fund industry. Africa just constituted 1.28

percent of world’s number of mutual fund schemes (ICI, 2009).

In terms of countries, Republic of Korea had the largest share (13.59%) in

number of mutual fund schemes at year end 2008. In terms of fastest growth in

number of mutual fund schemes from year end 2001 to year end 2008, Pakistan

(CAGR 63.63%), although on a very small base, was followed by Russia (CAGR

39.64%) and Chile growing at CAGR of 35.49 percent (ICI, 2009).

Six of the countries (out of 45) exhibited negative rate of growth in number of

mutual fund schemes. These countries are Costa Rica (CAGR -4.23%), United States

(CAGR -0.49%), Greece (CAGR -1.68%), Italy (CAGR -4.95%), Netherlands

(CAGR -1.85%) and Portugal growing at negative CAGR of 1.32 percent (ICI, 2009).

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Table 1.1 Regional / Country Wise Mutual fund Assets (In Million of USD) As of Year end 2008 (CAGR from Year end 2001 to year end 2008)

Region / Country Mutual Fund Assets Percent Share CAGR (%)* World 18974521 100.00% 7.21% Americas 10579430 55.76% 5.17% Argentina 3867 0.02% 0.44% Brazil 479321 2.53% 18.26% Canada 416031 2.19% 6.49% Chile 17587 0.09% 19.38% Costa Rica 1098 0.01% -5.04% Mexico 60435 0.32% 9.64% United States 9601090 50.60% 4.67% Europe 6288138 33.14% 10.29% Austria 93269 0.49% 7.78% Belgium 105057 0.55% 6.26% Czech Republic 5260 0.03% 16.76% Denmark2 65182 0.34% 9.82% Finland 48750 0.26% 20.87% France 1591082 8.39% 12.14% Germany 237986 1.25% 1.55% Greece 12189 0.06% -9.16% Hungary 9188 0.05% 22.18% Ireland 720486 3.80% 20.81% Italy 263588 1.39% -4.35% Liechtenstein 16781 0.09% 27.83% Luxembourg 1860763 9.81% 13.67% Netherlands 84568 0.45% 0.95% Norway 41157 0.22% 15.79% Poland 17782 0.09% 29.13% Portugal 14180 0.07% -2.24% Romania 326 0.00% 64.50% Russia 2026 0.01% 31.56% Slovakia 3841 0.02% 29.34% Slovenia 2067 0.01% -8.78% Spain 270983 1.43% 7.83% Sweden 113331 0.60% 8.14% Switzerland 165709 0.87% 11.79% Turkey 15404 0.08% 17.01% United Kingdom 526957 2.78% 7.54% Asia and Pacific 2037536 10.74% 10.10% Australia 841133 4.43% 14.10% China 276303 1.46% -36.34% Hong Kong 818421 # 0.00% 29.93% India 62805 0.33% 22.37% Japan 575327 3.03% 7.63% Korea, Republic Of 221992 1.17% 9.26% New Zealand 10612 0.06% 7.10% Pakistan 1985 0.01% -4.23% Philippines 1263 0.01% 29.13% Taiwan 46116 0.24% -1.08% Africa 69417 0.37% 25.00% South Africa 69417 0.37% 25.00% @ (Source: 2009 Investment Company Fact Book (2009). Various calculations have been performed by researcher) # data pertains to year end 2007

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Table 1.2 Regional / Country Wise number of mutual fund schemes @ As of Year end 2008 (CAGR from year end 2001 to year end 2008)

Region / Country Mutual Fund Schemes Percent Share CAGR (%)* World 69,032 100.00% 3.74% Americas 16,459 23.84% 2.93% Argentina 253 0.37% 2.08% Brazil 4,169 6.04% 7.88% Canada 2,015 2.92% 1.38% Chile 1,484 2.15% 35.49% Costa Rica 85 0.12% -4.23% Mexico 431 0.62% 3.02% United States 8,022 11.62% -0.49% Europe 36,780 53.28% 4.33% Austria 1,065 1.54% 4.76% Belgium 1,828 2.65% 8.38% Czech Republic 76 0.11% 2.26% Denmark2 489 0.71% 1.16% Finland 389 0.56% 5.08% France 8,301 12.02% 1.26% Germany 1,675 2.43% 6.51% Greece 239 0.35% -1.68% Hungary 270 0.39% 17.18% Ireland 3,097 4.49% 9.51% Italy 742 1.07% -4.95% Liechtenstein 335 0.49% 20.21% Luxembourg 9,351 13.55% 5.06% Netherlands 458 0.66% -1.85% Norway 530 0.77% 4.10% Poland 210 0.30% 12.17% Portugal 184 0.27% -1.32% Romania 52 0.08% 11.68% Russia 528 0.76% 39.64% Slovakia 56 0.08% 8.64% Slovenia 125 0.18% 14.11% Spain 2,944 4.26% 2.22% Sweden 508 0.74% 0.03% Switzerland 572 0.83% 9.00% Turkey 304 0.44% 3.87% United Kingdom 2,371 3.43% 4.44% Asia and Pacific 14,909 21.60% 2.96% China 429 0.62% 25.81% Hong Kong 1162 1.68% 3.38% India 551 0.80% 9.23% Japan 3,333 4.83% 2.17% Korea, Republic of 9,384 13.59% 4.03% New Zealand 643 0.93% 1.29% Pakistan 83 0.12% 63.63% Philippines 43 0.06% 11.56% Taiwan 443 0.64% 5.14% Africa 884 1.28% 10.99% South Africa 884 1.28% 10.99% @ (Source: 2009 Investment Company Fact Book. Various calculations have been performed by researcher) # data pertains to year end 2007

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1.4.2 United States Mutual Fund Industry1

United States Mutual fund industry is the largest in the world and it managed

approximately 10.35 trillion dollars in assets under management as of year end 2008.

This is approximately 52.0 percent of world mutual fund assets (19 trillion dollars) as

of the same time period. In the 10.35 trillion dollars of assets, managed by US mutual

fund industry, open ended mutual funds represented 9.60 trillion dollars (92.8 %).

Rest of the assets was shared between Close Ended Funds, Exchange Traded Funds

and Unit Investment Trusts.

US Mutual fund industry has been managing 19 percent of household financial

assets. Since 1990’s households have been shifting from direct purchase of equity and

bonds to their indirect purchase through mutual funds. The observed trend is mainly

due to two reasons – decline in equity mutual fund loads and improved confidence in

future family finances (Duca, 2005). Same trend has been observed in case of

institutional investors who also have been shifting majority of their cash holdings to

money market mutual funds.

United States mutual fund industry is skewed towards money market mutual

funds and stock funds. Both these categories comprised 78 percent of total assets

under management of open ended funds. Money market funds themselves comprised

40 percent of assets under management as of end 2008. Stock funds are divided as

domestic stock funds (which buy stocks of domestic corporations only) and

international stock funds. Of the total assets under management, domestic stock funds

constituted 29 percent and international stock funds constituted 9 percent of total

assets under management as of year end 2008. The other categories are bond funds

which constituted 16 percent and hybrid funds constituted 5 percent of total AUM.

Total assets under management have been divided into 8022 mutual fund schemes;

with equity constituting 4830 (60.2%), followed by bond fund schemes numbering

1916 (23.88%), money market schemes (9.77%) and hybrid fund (6.13%). With

respect to total individual shareholder accounts that US mutual fund industry

managed 66 percent belonged to equity, money market mutual funds (14.4%), bond

mutual funds (11.4%) and 7.8 percent belongs to hybrid funds. The close ended

1 The entire data for this section has been taken from various table(s) of Investment Company Institute (ICI) Fact book 2009. ICI represents the mutual fund association of all mutual funds operating in United States. ICI Fact book 2009 is the most reliable, updated and authoritative source of US Mutual fund industry. Various intermittent calculations and percent figures have been calculated by the researcher. The researcher of this thesis fully acknowledges the contributions of ICI Fact book 2009.

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mutual fund industry in United States is very miniscule as it managed only 300659

millions of US dollars under both equity and debt schemes with the help of 1070

schemes as of year end 2008 (ICI, 2009).

Total number of fund sponsors in US mutual fund industry stood at 678 as of

year end 2008 (down from 805 in 2000) who sponsored 8022 open ended mutual fund

schemes, 646 close ended mutual fund schemes and 743 exchange traded funds. Top

5 mutual fund complexes (or mutual fund houses) managed 38 percent of total assets

under management. Top 10 and Top 25 managed 53 percent and 75 percent of total

assets under management respectively as of year end 2008. During the last 15 years

(1994-2008), there has been a continuous positive and increasing net cash inflow to

the open ended mutual funds, except for 2003 when the industry witnessed negative

net cash flow. The average net cash flow to the open ended mutual funds during these

15 years stood at 321.6 billions of dollars per year (ICI, 2009).

The household ownership of US mutual fund industry has seen a significant

growth in the last 30 years. As of year end 2008, 45 percent of total US households

owned mutual funds. This stands tall in comparison with 6 percent of total US

households in 1980 who owned mutual funds. More than half of US households

headed by someone aged 45-54 years owned mutual fund in 2008. In total 82 per cent

of mutual fund assets is with the retail 92 million individual investors and only 18 per

cent of mutual fund assets is with institutional investors. Further individual investors

largely buy mutual fund from professional financial advisors (54% of sales) although

their role in selling of mutual funds is declining over the years (ICI, 2009).

1.4.3 Mutual Fund Industry in Other Regions

In European Zone, the mutual fund assets touched 4494275 million Euros at

the end of March 2009. The major share was held by Luxembourg (29.1%), France

(25.7%) and 8.3% in United Kingdom (European Fund Management Association,

2009). The main growth in Luxembourg was largely due to offshore mutual fund

investments in German origin banks based in Luxembourg and the local government

encouragement towards investments (Khorana et al, 2005).

In a study comparing US and European mutual fund industry, Otten and

Schweitzer (2002) reported that European mutual fund industry lagged the American

mutual fund industry in terms of total asset size, average fund size and market

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importance. In European countries few large fund houses dominate the market and

investors have a more liking towards fixed income based mutual funds as compared to

equity based mutual funds in America.

In a similar vein, Walter and Ciamarra (2007) examined the industrial

organization and institutional development of the asset management industry in Asian

developing economies - specifically in China, Indonesia, Korea, Malaysia, Singapore,

Philippines, and Thailand. They found that the fund management industry occupies a

very small niche in domestic financial systems that have been dominated by banks.

They also found that the growth of fund management industry has been very rapid in

the early 2000s which may persist as the pension fund sectors of the respective

economies have been liberalized to allow larger portions of assets to be invested in

collective investment schemes (like mutual funds).

1.5 Indian Mutual Fund Industry

1.5.1 History of Mutual Funds in India

The mutual fund industry in India had its origins in formation of Unit Trust of

India (UTI) in 1963 with initiatives from Reserve Bank of India and Government of

India. The objective was to channelize the savings of the small investors to the large

borrowers and in turn provide reasonable returns to the small investors. Since then

history of mutual funds in India can be broadly divided into four distinct phases.

In the first phase of industry development from 1964 – 1987, UTI was the

only player and it came up with first partially open ended scheme of Unit scheme-64

(US-64). Later in 1970s and 1980s, UTI started innovating and offering different

schemes to suit the needs of varied classes of investors. Schemes like Unit Linked

Insurance Plan (ULIP) in 1971, Children’s Gift Growth Fund in 1986 and

Mastershare (first diversified open ended equity fund) in 1987 were launched. The

first Indian offshore fund, India fund was launched in 1986. In 1987, i.e. at the end of

phase I, the total assets under management in Indian mutual fund industry were Rs

6700 crore and there was only one player in the industry i.e., UTI (Anjaria & Anjaria,

2001).

Second phase (1987-1993) marked the entry of public sector banks in the

Indian mutual fund industry. State Bank of India (SBI) established the first non-UTI

mutual fund by the name of SBI mutual fund in 1987, followed by Can Bank Mutual

21

Fund (1987), LIC Mutual fund (1989) and Indian Bank Mutual Fund (1990). These

were succeeded by Bank of India mutual fund, GIC mutual fund and PNB mutual

fund. At the end of 1993, the total assets under management in Indian mutual fund

industry touched Rs 47004 crore , approximately 7 times as of end of first phase

(Tripathy, 1996).

Phase 3 (1993-2003) saw the emergence of private sector mutual funds in

Indian mutual fund industry. Permission was also granted to foreign fund

management companies which were allowed to start their operations with formation

of joint ventures with the Indian operators. Kothari pioneer (later taken over by

Franklin Templeton group) was the first private sector mutual fund launched in Indian

mutual fund space. The private sector saw dramatic growth in this period partly due to

SEBI driven regulatory framework for mutual funds and also because of their good

performance. The inclusion of public sector mutual funds in this helped enlarge the

investor community. The first foreign name associated with the mutual fund appeared

in 1994 by the name of Morgan Stanley Mutual Fund (Anjaria & Anjaria, 2001).

Since 1996 onwards the tremendous growth in mutual funds owes to SEBI

regulations of Mutual funds in 1996, which was actually treated as the beginning of

the fourth phase. Similarly other events like Union Budget of 1999, which exempted

tax on dividend incomes of mutual fund, contributed much to the growth of the sector

(Anjaria & Anjaria, 2001).

Phase 4 (2003 onwards) saw bifurcation of UTI in two segments namely UTI I

and UTI II due to major financial and governance issues. UTI II later came to be

known as UTI mutual fund. Fund sector which was first shocked by UTI, later

recovered to register phenomenal growth (Chakrabarti, 2009).

Amidst growth, the mutual fund industry in India has witnessed other parallel

scenarios of mergers, acquisitions and consolidations. As for example, Franklin

Templeton, HDFC Mutual fund and Birla Sun Life took over big fund houses like

Kothari Pioneer, Zurich mutual fund and Alliance Capital respectively, propelling

them into big league. Among the smaller takeovers, Principal mutual fund bought out

Sun F&C schemes, while Canbank Mutual fund tookover GIC Mutual fund

(Chakravarty & Monga, 2006).

22

1.5.2 Structure of Mutual Funds in India

In USA, Corporation, Partnership or a Unit investment trust sets up an

investment company which further appoints a management company, which may be

close ended or open ended. It is the only open ended management company that is

known as mutual fund in USA. Management group (which may be a corporation or a

group of persons) or the fund house owns several such management companies. The

other constituents are the underwriter and custodian. Underwriter assumes the

function of distribution of mutual fund shares to the brokers or public. Custodian

holds the fund assets on behalf of Management Company (ICI, 2009). In United

Kingdom, separate regulatory mechanisms exist for both open ended (in the form of

unit trusts) and close ended funds (in the form of corporate entities called investment

trusts) (Anjaria & Anjaria, 2001).

In India, both open ended and close ended funds operate under the same

regulatory structure and are constituted as unit trusts. The structure of mutual fund is

laid down under SEBI (Mutual Fund) regulations, 1996. All the mutual funds have to

be registered with SEBI. Ministry of Finance ultimately supervises both the RBI and

SEBI, also it plays the role of appellate authority for any major dispute over SEBI

guidelines on certain specific capital market issues. The functions of bank owned

mutual funds are under the joint supervision of both the RBI and SEBI. Further as the

mutual funds, asset management companies and corporate trustees are registered as

companies under the Companies Act, 1956, they are subject to be regulated under its

provisions.

The various constituents of the mutual fund in India are – fund sponsor, board

of trustees, asset management company and custodian. Fund sponsor under SEBI

regulations establishes the mutual fund. Mutual fund in India is constituted in the

form of a public trust created under the Indian Trusts Act, 1882. Sponsor forms a trust

and appoints Board of Trustees (a body of individuals or a corporate body). Trustee

does not manage the portfolio directly, rather they appoint an Asset Management

Company (or AMC also known as fund manager). They ensure that the fund is

managed by AMC as per the stated objective of the scheme. Trust or the fund has no

legal capacity, it is only the trustee(s) who have the legal capacity and take all

decisions on the behalf of the trust. The trustee holds the unit holders’ money in

23

fiduciary capacity that is money belongs to the unit holders but is entrusted to the

fund for investment purposes.

Acting directly or in association with AMC, sponsor also appoints a custodian

to hold the assets of the funds. The custodian is appointed for safekeeping of the

physical securities and participating in any clearing mechanism through approved

depository companies on behalf of mutual fund. The funds dematerialized securities

are held by the depository through depository participant. Other major constituent in

the mutual fund ecosystem is the banker. A banker plays a crucial role with respect to

the financial dealings by the mutual fund and providing remittance services. Transfer

agents are responsible for issuing and redemption of units of the mutual fund and

provide other investor related services. They are an important interface between the

investor and the AMC as all the investor related services, except the investment

management function are performed by the transfer agent. Since mutual funds are

dependent on the money pooled by large number of investors, it becomes imperative

for them to reach the vast retail market, which they normally do by establishing

network of distributors or brokers or agents. The distribution network of mutual funds

is discussed in section 1.5.5.

It is pertinent to mention here that for the purpose of providing liquidity to the

investors, many close ended schemes of the mutual funds are listed on the stock

exchanges, which are therefore subject to their regulation. In case of UTI schemes

besides the SEBI Act, they are also regulated by the UTI act.

On the lines of industry association of mutual funds in USA (Investment

Company Institute), Association of Mutual Funds of India (AMFI) was set up in India

in 1995, with the objective of collective representation of mutual fund industry.

Specifically its objectives are to promote the interests of mutual funds and unit

holders; to set ethical, commercial and professional standards in the industry and to

increase public awareness of mutual funds (Anjaria & Anjaria, 2001).

1.5.3 Growth of Mutual Funds in India

According to Reserve Bank of India (2008) in 2007-08, gross financial savings

of the household sector was estimated at 15.6 percent of GDP. The major components

of financial savings estimated were –currency (10.9%); deposits (mainly bank

deposits) at 56.5 percent; shares and debentures (mainly non UTI mutual fund units)

24

at 10.5 percent; claims on government (mainly investment in small savings etc) at (-

3.7%); insurance funds (mainly life insurance) at 17.5 percent; and provident and

pension funds at 8.20 percent (Appendix I).

Although mutual funds just constituted 7.7 percent of total gross household

financial savings yet they compared well with -1.7% growth of investment in small

savings. Further there had been a significant increase in percentage of mutual fund

investments in gross household financial savings from 1.2 percent in 1993-94 to 7.7

percent in 2007-08. The effect becomes more pronounced when comparison is made

with the trend in investment in small savings which actually declined from 5.9 percent

in 1993-94 to -1.7 percent in 2007-08 (Reserve Bank of India, 2008).

As of March 2009, there were 35 active mutual fund houses (Appendix II) or

families or Asset Management Companies (AMCs) in India as compared to 9 fund

houses in 1993. Association of Mutual Funds of India (AMFI) classifies the AMCs in

three major categories namely Bank Sponsored AMCs, Institutions sponsored AMCs

and Private sector AMCs (Association of Mutual funds of India [AMFI], 2009).

Four bank sponsored AMCs contributed to 16.42 percent of assets under

management as of 31st March, 2009. Only one Institutional sponsored AMC (LIC

Mutual Fund Asset Management Company Limited) contributed 4.68 percent of

AUM. The private sector constituted 78.90 percent of assets under management in

Indian mutual fund industry as of 31st March, 2009 (AMFI, 2009).

As of March 31st, 2009, total assets under management in Indian mutual fund

industry were at Rs 417300 crore (AMFI, 2009). Assets under management have

been growing at increasing rate from financial year (FY) 1997 to FY 2009 at the rate

of 14.08 percent (Appendix III). There has been a marked increase in rate of growth

in assets under management; in the last 10 years (from FY 2000 to FY 2009) the rate

of growth has been observed at 16.21 percent as compared to 29.23 percent during the

last 5 years that is from FY 2005 to FY 2009 (Reserve Bank of India, 2008). The

average compounded growth rate of 29 percent in assets under management in India

from 2004-08 compares well with the world (4%), USA (4%), UK (2%), Europe zone

(3%) and Japan (10%). Out of BRIC countries, only China has recorded higher

growth rate (63%) in assets under management as compared to India, rest Brazil

(21%) and Russia (11%) lag behind (ICI, 2009). Further AUM to GDP ratio in case of

India was at 11 percent in 2009 as compared to 20-70 percent in developed countries

(KPMG, 2009).

25

Among Asset Management Companies, Reliance Capital Asset Management

Limited was the largest player in terms of AUM (16.41% market share) followed by

HDFC Asset Management Company Limited (11.75% market share ) and ICICI

Prudential Asset Management company Limited (10.43% market share) as of FY

2009 end. Further top 5 industry players had a market share of 50-52 percent of assets

under management as of March 2009. Top 10 industry players managed 75 percent of

assets under management. Industry concentration has largely remained stable in

Indian mutual fund industry from 2005-08 (KPMG, 2009).

Indian mutual fund industry is highly skewed in terms of investor ownership

(Appendix IV). As of March 2009, Corporates or institutional investment has been

highest in India at 50.92 percent of assets under management as compared to high net

worth individuals (HNIs – with the AUM of Rs 5.0 lakhs as defined by AMFI) at

22.03 percent and retail individual investors at 21.27 percent (AMFI, 2009). The high

percentage of corporate ownership is due to tax reforms instituted in 1999 that

lowered the tax rate on dividend and interest income (which was made lower even in

comparison to corporate tax rate levied on income from securities held directly by

Corporates) (Kamiyama, 2007). In terms of number of investors 97 percent has been

constituted by retail investors alone (AMFI, 2009) (Appendix V).

As of 31st March, 2008 total number of mutual fund accounts were 42 million

folios (out of 1.15 billion population), including multiple folios. This is in deep

contrast with US figures as there were 92 million folios (out of 305 million

populations) in the same time period (KPMG, 2009). In terms of number of investor

portfolios, corporate investors and HNIs constituted just 1.22 percent and 1.29 percent

whereas retail investors constituted phenomenal 97.47 percent share of number of

portfolios in mutual fund industry (AMFI, 2009).

Out of the total assets under management as on 31st March, 2009; Income

funds was the largest category of funds as it constituted 47.29 percent of total AUM

followed by equity (22.96%) and liquid and money market funds (21.71%) (Appendix

VI). Major share of the funds were of open ended category (77.90%). Retail investors

had been more dominant in equity mutual funds (64.8%) and balanced mutual funds

(68.2%) (AMFI, 2009).

Top 10 cities in India contributed towards 80 percent market share in mutual

fund assets under management as of Dec 2008, but their share has been declining, as

the mutual funds are fast spreading towards Tier II and Tier III cities, thanks to the

26

efforts of the entire distribution channel. Total number of mutual fund schemes as of

Dec 2008 was 1002 as compared to 8002 in USA. In terms of underlying investments,

debt mutual funds occupied 47.29 percent of total AUM, equity based mutual funds

constituted 22.96 percent of total AUM and liquid funds constituted 21.71 percent of

total AUM. Open end mutual funds represented the largest category as they

constituted 99 percent of the number of schemes or 77.9 percent of assets under

management. In terms of scheme wise compounded average growth rate from FY

2005 to FY 2009, equity funds represented the highest growing category, growing at

the rate of 30 percent, followed by balanced funds, liquid funds and debt funds at 22

percent, 14 percent and 4.1 percent respectively (KPMG, 2009). New products like

Exchange traded funds, Gold ETFs, Capital protection funds and oversees funds have

been gaining popularity but still they occupy miniscule share of Indian mutual fund

industry.

There were 92,499 mutual fund distributors as of March 2009. Out of these 73

percent were independent financial advisors, 21 percent corporate employees and 6

percent were corporates. Banks dominated mutual fund distribution with 30 percent

AUM share. National and regional distributors in addition to independent financial

consultants constituted 57 percent of AUM share as of year end 2007 (KPMG, 2009).

In addition as of 31st March, 2008, Indian capital market had the support of 19 stock

exchanges (cash segment), 2 stock exchanges (derivatives segment), 9487 brokers

(cash segment), 4190 corporate brokers (cash segment) and 44074 sub brokers (cash

segment) assisting mutual fund industry (Securities and Exchange Board of India,

2009) .

1.5.4 Classification of Mutual Funds

Mutual funds are classified on several parameters. Normally they are

classified on the basis of their constitution (open ended versus close ended funds); on

the basis of their loads (‘no load’ or load funds); on the basis of tax (‘tax saving’ or

‘non tax saving funds’) and on the basis of investable asset (equity funds, debt funds,

balanced funds, or money market funds).

In an open ended fund, units of the mutual fund are available for sale and

repurchase at all times (normally at daily intervals). The sale and repurchase of units

is done at Net Asset Value (NAV) from / to Asset Management Company (AMC)

27

only. NAV is obtained by dividing the amount of the market value of the fund’s assets

(plus accrued income minus the fund’s liabilities) by number of outstanding units.

Both the fund size and the unit capital (number of outstanding units) vary in the open

ended fund. In comparison, the close ended fund has a fixed unit capital as it makes

one time offering to the investors. In order to provide liquidity to the close ended fund

investors, these funds are listed on the stock exchange, which may trade at a premium

or discount to the underlying NAV (Lee et al, 1991). Close ended funds are redeemed

only at the maturity of the fund. Indian mutual fund industry also provides the

intermediate kind of funds to the Indian investors, which are a type of hybrid between

open ended and close ended funds. These types of funds are known as Interval funds.

Principally these funds are close ended, but they frequently open for purchase and sale

after a set interval, thereby improving their liquidity characteristics.

On the basis of load, funds are classified as ‘load’ or ‘no load’ funds.

Securities and Exchange Board of India (SEBI) defines ‘load’ as one time fee payable

by the investor to allow the fund to meet initial sale expenses (Anjaria & Anjaria,

2001). Apart from initial sales expenses, funds also charge management fees or other

recurring expenses. So ‘no load’ fund only avoids sale expenses, but has to pay

management fees or other recurring expenses. Mutual fund loads can be charged in

four ways namely front end load or entry load (which is charged from the investor

when ever he invests in the fund); exit load or back end load (load which is charged at

the time of redemption from the fund); deferred load (load charged over a period of

time) and finally contingent deferred sales charge (load which is contingent upon the

time investor stays with the fund). SEBI has come up with landmark regulations

regarding the loads. In Jan 2008, SEBI came up with the regulation that no load has to

be charged from the investor (even if is the load fund) if he submits his investment

application directly into an AMC office (National Stock Exchange of India Limited,

2009). Since 1st August, 2009, the entire distribution channel of the mutual funds in

India has been revamped as the regulation of variable load came into picture. With

this regulation, investor has to pay the load (according to his perceptions about the

service received from the intermediary) as a separate cheque amount to the

intermediary and load is not to be subtracted from the investment amount of the

investor (Sehgal, 2009).

Mutual funds are also classified as ‘tax exempt’ and ‘non tax exempt’ funds.

There are mutual funds which are used for tax saving (commonly known as equity

28

linked saving schemes). These are used for getting rebate under section 80C of the

Income tax act, up to maximum investment of rupees one lac only. These funds have

a lock in period of 3 years as compared to other open ended funds.

On the basis of nature of investments, funds are classified as Equity funds

which predominantly invest in listed or unlisted equity; Bond funds which

predominantly invests in fixed income products and money market funds which

predominantly invests in money market instruments. On the basis of investment

objective, funds are classified as growth funds, which invests for medium to long term

and prime objective is capital appreciation; income funds, which invests to generate

regular income and there is less orientation towards capital appreciation; value funds,

which invests in sound fundamental investment instruments that are under valued at

present. There is another class of funds known as balanced funds which try to have

the virtues of both equity and debt and provide hybrid product to the investors. By

investing in a mix of equity, debt and money market instruments, balanced funds seek

to attain the objectives of income, moderate capital appreciation and preservation of

capital. Balance funds or hybrid funds can be debt oriented or equity oriented as per

the mandate of the scheme.

Money market funds are the least risky ones which invest in money market

instruments of short maturity (less than one year). The instruments typically used are

government treasury bills, certificate of deposits issued by banks, commercial papers

issued by the companies and inter bank call money market. These funds are very

liquid and exhibit high safety.

GILT funds invest in government securities (which are having maturity of

more than one year). These funds are free from default risk and hence offer better

protection of capital to the investors. Debt funds or Income funds invest in debt

offered not only by the government but also by the private companies and other

government and semi government institutions. These funds have significant interest

rate fluctuation risk as they invest in maturities of more than one year. These funds do

have a higher default risk as compared to the GILT funds. The basic orientation of

debt funds including GILT funds is higher income generation and not the capital

appreciation. There are some diversified debt funds which invests in mix of

government securities, corporate bonds and money market instruments. Debt funds

have several special categories of funds like monthly income plans (which are mixture

of high percentage of debt and low percentage of equity), floating rate funds (which

29

try to mimic the rate of return equivalent to current market rates) and fixed maturity

plans (which are close ended funds that try to align the maturity of the scheme with

the maturity of the underlying assets). Further debt funds are also classified on the

basis of tenure of the assets – they can be of long term, medium term, short term and

ultra short term. In addition there can be separate funds for the retail and institutional

investors.

Equity funds invest major share of their corpus in equity and equity related

instruments like futures and options either through primary market offering or through

purchase from the secondary market. Equity funds are of various types like diversified

funds, which invest in large number of shares across market caps and sectors. The

main aim of these funds is to diversify risk by investing in different market caps or

sectors. Equity funds are also classified on the basis of objective like growth and

value funds or the blend. They are also classified on the basis of market cap in which

they are investing (like large cap funds, mid cap funds, small cap funds and micro cap

funds). Equity index funds are another category which invests in the shares of the

benchmark in the same proportion as they are in the benchmark. Further there can be

thematic funds (like infrastructure or media funds) which invest in the chosen theme.

There can be sectoral funds (for example banking sector or pharmaceutical) which

invest in particular sector. Some of the fund houses have launched opportunities fund,

which invests in equity and equity related instruments as per the opportunity available

in terms of superior risk adjusted returns. These funds do not have any specific bias to

any style or market cap. Indian mutual fund industry is also providing the facility of

investing in foreign equity through specialized mutual fund schemes.

Apart from debt and equity funds, other categories can be commodity funds

(which invests in commodity based stocks), real estate funds (which invests in real

estate stocks). Indian market has also seen the growth of other kind of special

products like Exchange traded funds (which are index based and traded on stock

markets), arbitrage funds, which take opposite positions in both cash and futures

market and take the advantage of any mis-pricing between the two; dividend yield

funds (which invests in the sound companies having dividend yield more as compared

to the benchmark). There is another class of funds known as asset allocation funds,

which have almost fixed and predefined asset allocation policies and the weights

associated with the assets depend on state and preference given by the investors. It

particular it is important to mention here that Exchange Traded Funds are kind of

30

innovation as they provide investors a fund that closely tracks the performance of an

index and are able to buy/sell on intra day basis, as compared to only one single daily

price in all non exchange traded funds. There is another class of funds known as

special situations fund, which as per their name, invests in and take benefits of special

situations like budgets, corporate restructuring etc. Contrarian funds represent yet

another class which invests in securities which are not popular in the market during

the specific time period, but are representing sound fundamental businesses.

Some new asset classes are also offered to the Indian investors, like quant

funds which invest according to some quantitative model. Also there are Capital

Protection Funds, which make use of derivative markets in association with debt and

equity markets thereby trying to preserve invested capital using some structured

products. Another variant of capital protection mutual fund scheme is assured return

scheme which assures a specific return to unit holders irrespective of scheme

performance.

In recent years another category of funds is being developed which has the

potential of offering investors a highly diversified fund portfolio. Such a category is

known as Fund of Funds. These are the funds which invests in mutual funds across

the fund houses domestically or globally.

It can be therefore inferred that mutual fund industry has a lot to offer in terms

of products and variety which may suit to almost every need of the investor. Now the

onus is on the investor to choose or select the mutual fund so that he can achieve his

objective of getting reasonable risk adjusted returns, contingent upon his risk profile.

1.5.5 Distribution and Marketing of Mutual Funds in India

For a mutual fund to succeed, wide investor participation is essential. The

broader and wider participation can only be achieved, if there is a strong network of

distributors and agents. Mutual fund industry has been able to form a stronger, wider

and broader network of middleman to market and distribute its products and services.

At present mutual funds are being marketed and distributed by brokers, sub-brokers,

independent financial agents (commonly known as IFAs in industry parlance),

national or regional distributors, banks, financial institutions, Non-banking financial

companies (NBFCs), post office, AMC offices and employees etc. Further with the

31

onset of electronic commerce any of these intermediaries can market the products

physically or with the help of internet.

Brokers are usually the brokers associated with the stock exchange (they hold

the membership seats), so besides equity they also market mutual fund schemes as

they have clients who usually have common interests. Sub brokers are further

associates of big brokers, who do not have their own membership seats but they act on

behalf of the brokers.

The biggest force in marketing of mutual fund products is perhaps of the

independent financial agents or in short ‘agents’. They are different from brokers as

they are not associated with the stock exchange, nor they are the employees of any big

broker. They act independently and use to sell the mutual fund largely on relationship

basis. They largely feed to the retail clients. National or regional distributors are

usually the non banking financial companies (NBFCs) which are into marketing and

distribution of mutual fund products. They are classified on the basis of their reach; as

national distributors have nation wide presence and regional distributors are mainly

confided in the particular region only. Both the national and regional distributors feed

both retail and non retail clients. Banks are the other emerging strong force in the

marketing and distribution of mutual fund products. Since banks have wider reach and

vast database of their customers, they can and have already demonstrated the skill of

mutual fund marketing. Normally banks involve themselves in cross selling of

financial products. Guidelines from the SEBI in 2003 require that personnel who sell

mutual funds in India should pass the Association of Mutual Funds of India (AMFI)’s

mutual funds advisory module and receive registration number from AMFI

(Kamiyama, 2007).

Since the Jan 2008 regulation of SEBI regarding entry loads which states that

a direct applicant to AMC office has not to pay any loads, many of the investors have

turned towards this method of investing thereby ultimately saving the entry loads they

used to pay (National Stock Exchange of India Limited, 2009). AMC offices and their

employees along with the registrar and transfer agents accept the application forms

and in this way contribute towards its marketing and distribution. Post offices are also

contributing towards the marketing of some mutual fund schemes. But seeing the

wider reach of the post offices in India, this channel has not able to exploit its

competitive advantage as far as marketing of mutual funds is concerned.

32

Many of the intermediaries today have opened up their websites and enable

the investors to do any sort of transaction through their web. Almost all top AMCs

(and many others are in the process of establishing) have transaction enabled

websites, which makes it easier for investor to do any kind of mutual fund related

transaction.

1.5.6 Future Prospects of Mutual funds In India

No doubt that mutual fund industry in India has achieved tremendous growth,

from one player industry in 1987, it has touched around 40 players and many more are

waiting to come in. On the global level, India had just 0.32 percent share of global

assets under management as of Dec 2008 (ICI, 2009).

The domestic scenario is also not encouraging as industry has penetrated into

just 4 percent of population (Somvanshi, 2009). Over the past 10 years, on an average,

while bank fixed deposits accounted for an average 33 percent of total financial

savings of Indian households, Indian investors have invested on an average just 1.11

percent of their financial savings in mutual funds. Reasons cited are mainly – bad

show of Indian capital markets during 1990s, various financial scams and similarity in

the product offering mainly by all asset management companies (Monga, 2006). This

is in fact a two way signal, one interpretation is that Indian investors are risk averse

and don’t want to build significant positions in the market related instruments. The

other interpretation is that such a low penetration signifies the tremendous potential

ahead.

Moreover with the rising income levels; the penetration of financial products

in rural areas; increasing disposable income due to tax cuts and increase in salaries;

increasing financial literacy; effort of the companies and intermediaries involved to

increase the financial product awareness; tax incentive(s) by the government;

increasing base of Indian middle class; and increasing risk seeking behaviour of the

Indian investors may definitely help the mutual fund industry in India to grow by

leaps and bounds in the years to come.

At the end of financial year 2009, as percentage of GDP, assets under

management of funds were about 10 – 11 percent as against 60 percent in developed

countries (KPMG, 2009). The BRIC study of 2003 changed the thinking paradigms of

foreign financial institutions and all were seen to set some base in BRIC countries

33

(Kamiyama, 2007). As a result of these as many as 16 international fund houses like

Sumitoo, Nikko, Shinsei, Nippon Life, Goldman Sachs etc have been waiting or are in

the process to set up AMC offices in India seeing the future potential of Indian capital

markets in general and mutual funds in particular (Adjania, 2007).

In terms of the product variety offered to the Indian investors, very soon more

varied, customized products will come to India. Products like option write mutual

funds, real estate mutual funds, collective investment schemes, art funds, mortgage

backed securities funds, and structured products will come in a big way and add value

to the investors’ portfolio. Already the inclination of regulators towards success of

National Pension Scheme will give a major boost to asset management industry in

general and mutual fund industry in particular. The success of this scheme will

definitely generate an inclination of Indian investors towards mutual fund products,

and ultimately this will largely benefit the mutual fund industry in a big way.

Indian capital markets today offer a great opportunity. Very few countries in

the world are growing at the rate today, at which India is growing. Moreover India is

often perceived to be the services conglomerate as demonstrated by the higher share

of services in GDP as compared to agriculture and manufacturing. Very little damage

and impact of great global recession of 2008, on Indian economy (as compared to

other countries) was reported in media. This will definitely make India a likely choice

of foreign portfolio and FDI investments in a big way. And all these pointers are

indicative of a healthy and vibrant mutual fund industry in India.

1.6 Rationale of the study

Modern finance theory rests on the assumption that purchase decision for

individual financial assets should be made on the basis of investors’ anticipation

regarding the future returns and risk of the asset and the covariance of these returns

with other financial assets in investor’s portfolio (Markowitz, 1959; Elton & Gruber,

2001). In view of this, most of the research on mutual fund selection and thereby

purchase extensively used only two explanatory variables namely return and risk

performance. Post the development of portfolio theory, various measures of mutual

fund performance have been developed (for example Treynor, 1965; Sharpe, 1966;

Jensen, 1968; Fama, 1972 etc). The results of the mutual fund out performance

(relative to the broader market or the benchmark selected) have been found to be

34

largely mixed. Although there are some studies which indicate that mutual funds

under perform the market (for example Sharpe, 1966; Jensen, 1968) yet there are

others which indicate otherwise (for example Ippolito, 1989; Grinblatt & Titman,

1989a).

The idea whether historical performance is indicative of future performance

(performance persistence) has been extensively studied and reported in mutual fund

literature. Here again, mixed results and observations have been found. Some studies

do find persistence in performance (for example Lehman & Modest, 1987; Ippolito,

1989 etc) yet there are others which indicate either no persistence or persistence of

inferior performance (for example Shukla & Trzcinka, 1994). Almost similar results

have been found in Indian mutual fund industry (for example Chakrabarti & Rungta,

2000; Singla & Singh, 2000).

If performance persists, it may be due to market timing or stock selection

ability of fund manager. Internationally, market timing ability of mutual fund has

been found to be neutral (for example Kao et al, 1998) or inferior (Chen et al, 1992).

On the other hand, stock selection ability has been found to be less (Chang &

Lewellen, 1985) or positive (Lee & Rahman, 1990). Results on market timing ability

and stock selection from Indian studies are more or less similar to the findings from

the international studies.

Thus studies on mutual fund performance failed to establish it as only reason

for mutual fund selection. Capon et al (1996) argued that mutual fund performance is

one part of multi attribute decision making with respect to fund selection, a view

which is further strengthened by observations from Campenhout (2007) who stated

that there is no single theoretical framework of fund selection. So apart from the most

widely cited explanatory variables of return and risk in mutual fund / scheme

selection, several other external variables have been studied and reported. Notable

among these attributes are services (Sirri & Tufano, 1992); Expectation of change in

management strategy or management team, especially with respect to poor

performing funds (for example Lynch & Musto, 2003); Expenses and fees,

diversification level, ratings as formulated by different investors according to their

attitudes and preferences (Cook & Hebner, 1993); Fund manager and fund family

reputation, recommendations from a financial magazine, clarity of account statement

etc (Capon et al, 1996); Retirement preparedness (Morgan, 1994) etc. Certain

behavioral tendencies have also been found to be associated with mutual fund or

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scheme selection. Prominent among these are Cognitive dissonance2 (Festinger,

1957); Representativeness heuristic3 (Goetzmann & Peles, 1997) Disposition effect4

(Shefrin & Statman, 1985) and Endowment effect5 (Kahneman et al, 1992).

Information sources also play a considerable role in influencing purchase decision

(Carroll, 1990; Crossby & Stephans, 1987).

Selection criteria include the set of product and service attributes that investor

consider when making a purchase decision among alternatives. For a given purchase

three set of variables namely – individual, brand or product characteristic and

purchase context, jointly determine the particular selection criteria employed (Capon

et al, 1996). Individual factors include various demographic and psycho graphic

characteristics of decision makers (Maheswaran & Levy, 1990). Brand or product

characteristics include product features or attributes (for example price, quality and

performance – return and risk in case of mutual fund purchase). Finally purchase

context (for example internal and external framing of the purchase decision) has a

significant impact on selection criteria.

As previously explained gamut of international studies on different aspects of

mutual fund selection behavior highlights some points. Firstly return and risk

although are very important attributes, yet represent only two attributes in multi

attribute framework of fund selection behavior. Not only other product and service

attributes, but also behavioral tendencies affect fund selection. Since most of the

studies focus on return and risk, the value of other attributes in fund selection

behaviour demands attention. Moreover there is a strong evidence to the fact that

people add value to other attributes for example evidences like frequent selling of

close ended mutual funds at substantial discount or premium to the underlying Net

Asset Value (NAV) of their component securities (Lee et al, 1991); investments in

socially responsible funds in spite of their equivalent or poor performance (for

example Hamilton et al, 1993; Bauer et al, 2005) bears testimony to this.

In addition to the gamut of selection criteria involved, additional complexity

comes from enormous number and variants of mutual fund schemes. Further for most

of the investors, decision to select mutual funds is highly dependent on mutual fund

2 Tendency to adjust belief to justify past actions 3 Belief that small sample is over representative of population from which it is drawn 4 Inclination to sell winners and retain losers because of asymmetric attitude towards utility from gains and losses 5 People’s belief that something they own is better than something they do not own

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intermediaries, whose selection criteria or their perception of investor’s selection

criteria may make mutual fund selection a tough one. In view of this the following

study aims to answer the questions like – how investor selects the fund, how retail

investors differ from non retail investors in their fund selection behavior and finally

how intermediaries perceive about how investors select the funds.

1.7 Objectives of the study

In India although growth in mutual funds especially in last few years is

phenomenal, but very less research has been conducted to study the investor selection

behavior. Since many new facilities and lot number of innovations have been

incorporated in mutual fund offerings, the existing literature barely covers the investor

behavior towards it. Also very few attempts have been made to study the non retail

investor behavior towards investment / selection of mutual funds. Similarly, studies

relating to perception of mutual fund intermediaries regarding behavior of retail and

non retail investors in mutual fund / scheme selection are very few. In view of this

following objectives have been framed for the present study.

I. To identify the sources of information for retail and non retail mutual fund

investors

II. To make a comparative analysis of factors influencing the behaviour of retail

and non retail investors regarding mutual fund / scheme selection

III. To study the perception of intermediaries in mutual fund distribution

channel regarding the factors influencing the behaviour of retail and non

retail investor with respect to mutual fund / scheme selection

IV. To explore the implications of fund selection behaviour for asset

management companies.

1.8 Organisation of the Study

The thesis has been divided into eight chapters. Current chapter (Chapter I)

deals with the mutual fund – its origin and history; concept and definition; detailed

discussion on global mutual fund industry; mutual fund industry in US (largest mutual

fund market) and mutual fund industry in other regions. The mutual fund industry in

India – history, structure and growth is also suitably discussed. Relevant discussions

regarding classification of mutual fund schemes, distribution and marketing of mutual

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funds in India and future prospects of mutual funds in India have been made. In the

end rationale of the study and specific objectives of the study have been mentioned.

Chapter II deals with the discussion of relevant literature on mutual fund

performance- development of measures of performance; out or under performance;

mutual fund performance persistence and factors affecting mutual fund performance.

Literature concerning mutual fund managers’ stock selection and market timing

ability has also been suitably discussed. Comprehensive studies on mutual fund

selection behavior and isolated studies linking mutual fund flows with selected

determinants have been discussed in thorough detail. The mutual fund selection

frameworks of behavioral decision framework and consumer decision framework

have also been covered in detail. A separate section in the chapter has been devoted to

the coverage of Indian studies regarding all the aspects listed above. The last section

deals with the discussion on research gaps.

Chapter III deals with the detailed discussion on research methodology for the

achievement of specific objectives of the study. The first section deals with the listing

of hypotheses of the study followed by extensive discussion on sampling design.

Discussion on data collection; questionnaire structure and content have been

appropriately incorporated. The procedure for carrying out entire analysis of the data

has been discussed in detail under the two heads of preliminary data analysis and

factor analysis. Last section of the study deals with limitation of the study

Chapter IV concerns with the discussion of investors’ profile (demographic,

economic, purchase) and purchase behavior with respect to both retail and non retail

investors. Objectives and advantages of investing in mutual funds have also been

suitably discussed. Last section extensively deals with the observations, analysis and

discussion of sources of information for both retail and non retail investors followed

by observations of factor analysis of the sources of information construct and its

interpretation.

Chapter V deals with the extensive discussion on investor’s fund selection

criteria constructs (mutual fund schemes, mutual fund companies, investor services

and behavioral biasness) – variable wise importance and factor analysis thereof.

Chapter also incorporates observations and discussion on differences between various

subsets of investors, subdivided according to various criteria, regarding importance to

the constructs of mutual fund selection behavior.

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Chapter VI deals with discussion on profile of intermediaries, perception of

intermediaries regarding investor’s purchase behavior, purchase profile, investor’s

attitude towards importance of objectives and advantages of investing in mutual funds

and importance of fund selection criteria constructs as assigned by the investors and

perceived by intermediaries. The chapter also includes discussion on comparison

among different types of intermediaries regarding their perception of investor’s fund

selection behavior.

Chapter VII deals with implications and recommendations of the study on

asset management companies and intermediaries. Specifically implications of

comparison between retail and non retail mutual fund investor regarding their fund

selection behavior have been included. The chapter also discusses about implications

of intermediaries perception; implication of investors’ demographic and economic

characteristics and implications of investors’ purchase behavior and purchase profile

on asset management companies. Chapter VIII deals with the summary of the entire

study