Performance and Regulation of Mutual

Funds in India: An Economic Analysis

A thesis submitted to the University of Mysore, Mysore, through the
Department of Studies in Economics and Cooperation, University of
Mysore, Mysore,
For the Award of the Degree of Doctor of Philosophy in Economics
By
T.S. SOMASHEKAR
Under the supervision of
Dr. S. Madheswaran
Institute for Social and Economic Change, Baogalore
December 2008
DEDICATED TO MY WIFE, KAVITHA
FOR ALL THE MORAL SUPPORT
DECLARATION
I hereby declare that the thesis entitled "Performance and
Regulation of Mutual Funds in India: An Economic Analysis" is a
result of research work carried out by me at the Institute for Social
and Economic Change (ISEC), Bangalore, under the guidance of
Dr.S.Madheswaran, Professor, Centre for Economic Studies and
Policy, ISEC, Bangalore.
I further declare that it has not been previously submitted, in part
or full, to this or any other university for any degree. Due
acknowledgements have been made whenever anything has been
borrowed or citied from other sources.
Research Scholar
Centre for Economic Studies and Policy (CESP)
Institute for Social and Economic Change
Bangalore - 560 072
India
INSTITUTE FOR SOCIAL AND ECONOMIC CHANGE
Dr V K R V Rao Road, Nagarabhavi P.O., Bangalore - 560072
Fax: 080-23217008
website: www.isec.ac.in
Email: madhes@isec.ac.in
An all India institute for inter.<fisciplinary research and training in the Social Sciences
CERTIFICATE
This is to certify that the thesis entitled RPeriormance and
Regulation of Mutual Funds in India: An Economic Analysis" .
submitted by T.S.Somoshekar in fulfillment of the requirements for
the award of the degree of DOCTOR OF PHILOSOPHY in
ECONOMICS is an original work.
I also certify that it has not been previously submitted for the
award of any degree or diploma or associate fellowship of the
University of Mysore or any other University.
S. y.JL.....y

Supervisor
Professor
Centre for Economic Studies and Policy
Institute for Social and Economic Change
Bangalore -560 072
India
ACKNOWLEDGEMENT
It is with a sense of achievement and pride that I complete my thesis. It has
been made possible by the unstinting support of many people. These few
words only convey my formal thanks but cannot convey the depth of my
gratitude to them.
I have to begin by thanking my supervisor Prof Dr. S Madheswaran, under
whose able guidance this work has been carried out. His constructive
criticism, patience in going through my work, simplifying suggestions,
constant encouragement and rock solid moral support has gone a long way in
helping me complete my thesis. I am grateful to him for this.
I would like to express my thanks to my Doctoral committee members
ProfMR.Narayana and ProfMeenakshi of ISEC, for sparing their valuable
time in going through my draft and providing constructive invaluable
suggestions and moral support. Sincerely acknowledge their help.
I am grateful to the previous directors, ProfMGovinda Rao, ProfGopal
K.Kadekodi, ProfNJayaram and the present director ProfDeshpande of the
Institute for Social and Economic Change (ISEC), for their support and
encouragement.
I am deeply indebted to the Institute for Law and Economics, University of
Hamburg for selecting me and providing me an opportunity to pursue my
doctoral research. I express my sincere gratitude to my guide at the Institute,
Prof A Domadoran, Indian Institute for Management, Bangalore for their
patient guidance in my quantitative analysis.
I also sincerely acknowledge the valuable comments and suggestion of
ProfShashank Bhide, ProfMRamachandran, Ms. B. P. Vani, Assistant
Professor, ISEC, ProfNSSNara
The important role of a fund manager Mr.Harsha, in UTI Mutual Fund Ltd,
in terms of fund manager realities has been of immense help. lowe him my
gratitude.
My Sincere gratitudes are due to ProfS N Sangita, Dr. Mahadeva,
Dr.K.G.Gayathri Devi, Dr.MD.Usha Devi and Dr.Anand Inbanathan for
their encouragement and held during the course of all my biannual seminars
in ISEC. I am also thankful to other faculty members of ISEC for their
encouragements.
My special thanks to Mr.K.s.Narayanafor helping me with the editorial work
and tremendous support at different stages of my thesis work. To
Mrs.Susheela the efficient typist lowe a lot of gratitude. 1 acknowledge the
assistance received from the computer staff Mr. Krishna Chandran and
Mr.Satish kamat and also the ISEC library staff, Mr. Sharma, Mrs. Lila,
Kalyanappa, Suresh and Rudresh.
Further, 1 express my sincere gratitude to the University of Mysore, faculty
members at Department of Economics and staff for aI/owing me to register
for Ph.D and their valuable suggestions and kind cooperation.
1 take this opportunity to thank my fellow Ph.D students and friends
Badrinarayan Rath, Mahesh, Nisha, Subir and Venugopal, who were always
there in times of need.
I am deeply indebted to my parents and my wife for aI/ the moral support and
encouragement in my academic pursuits.
T.S.Somashekar
CONTENTS
Chapter I - Introduction
1.1. The concept of Mutual Funds
1.2. Organization of Mutual Funds in India
1.3. Types of Mutual Funds
1.4. The Mutual Funds Industry in India
1.5. Statement of the Problem
1.6. Review ofTheoretical Studies
1.7. Review of Empirical Studies
1.8. Objectives of the Study
1.9. Analy1ical Tools
1.10. Relevance of the study
1.11. Scope of the Study
1.12. Data Description, Sources and period of Study
1.13. Chapter Scheme of the Study
Chapter II - Review of Literature
2.1. Introduction
2.2. Theoretical Review
2.2.1. Theories of Regulation
2.2.2. TheOries of Risk Measurement
2.3. Empirical Review
2.3.1. Review of Studies on Mutual Funds performance
2.3.2. Empirical studies on Indian Mutual Funds
2.3.3. Empirical Studies on Fund Size and Returns
2.3.4. Fund Style and Fund Returns
2.3.5. Empirical studies on Indian Mutual Funds
Page No.
1 - 28
29-47
Chapter III - Performance of Equity Funds using Variance and
Semi-Variance of Risk
3.1. Introduction
3.2. Empirical framewor1< and Data description
3.2.1. Empirical framewor1<
3.2.2. Data
3.3. Results and Analysis
3.4. Conclusions
Chapter IV - Regulatory Constraints And Fund Performance -
Comparing Alternate Regulatory Regimes
4.1. Introduction
4.2. Comparison of the Regulatory structure of SEBI (Regulations)
and UTI Act (1963)
4.2.1. UTI Act of 1963 and ~ s constraints on fund behaviour
4.2.2. SEBI Regulations and its constraints on fund behaviour
4.3. Empirical framework, data description and methodology
4.3.1 Empirical framewor1<
4.3.2. Data
4.4. Results and Analysis
4.5. Chapter Summary
Page No.
48-58
59-86
Chapter V - Cost-Management Fee Regulation and Economies 87 -107
of Scale
5.1. Introduction.
5.2. Regulation of costs and management fees
5.3. Empirical framewor1<, Data description and Methodology.
5.3.1. Data
5.3.2. Empirical Framewor1<
5.4. Results and analysis
5.5. Cost composition: Management fees, mar1<eting expenses and
other expenses
5.S. Chapter Summary
Chapter VI - Fund Size and Fund Returns
6.1. Introduction
6.2. Empirical framework and data
6.2.1. Data
6.2.2. Empirical framework and model
6.3. Resuijs
6.4. Chapter Summary
Chapter VII - Summary of Findings and Policy Suggestions
7.1. Summary
7.1.1. Relative Fund Performance Using Altemate Risk Weighted
Returns: Mean-Variance and Lower Partial Movement
7.1.2. Regulatory Constraints and Fund Performance- Comparing
Alternate Regulatory Regimes
7.1.3. Cost- Management Fee Regulation and Economies of Scale
7.1.4. Fund Size and Fund Returns
7.2. Lim itations of the Study
7.3. Further Scope for Study
7.4. Policy Suggestions and Concluding Observations
References
Page No.
108 - 121
122 - 132
133 -138
III
List of Abbreviations
NAV
Net Asset Value
AUM
Assets Under Management
SEBI
Securities and Exchange Board of India
GIPS
Global Investment Performance Standards
TWR
Time Weighted Return
EXR
Excess Return
SR
Sharpe Ratio
IR
Information Ratio
TE
Tracking Error
SOR
Sortino Ratio
MAR
Minimum Acceptable Return
CAPM
Capital Asset Pricing Model
UTI
Unit T rust of India
OEG
Open end Equity Diversified Growth Funds
CIU
Collective Investment Vehicle
CIS
Collective Investment Schemes
AMC
Asset Management Company
VCF
Venture Capital Fund
IPO
Initial Public Offer
TM Treynor Mazuy
ELSS
Equity Linked Savings Scheme
VCF
Venture Capital Funds
RBI
Reserve Bank of India
137
AMC Asset Management Company
FT Franklin Templeton
BSE Bombay Stock Exchange
ETF Exchange Traded Fund's
US Unit Schemes
LlC Life Insurance Corporation of India
GIC General Insurance Corporation of India
\38
PgNo.
Chapter I - Introduction
Table 1.1: Comparative AUM as a percent of GDP (CMP) in 2004
11
Chapter III - Performance of Equity Funds Using Mean-Variance
And Lower Partial Movement
Table 3.1: Sample of Equity Diversified Funds 52
Table 3.2: Sharpe Ratio ranking of funds 53
Table 3.3: Treynor Index Rankings fund 54
Table 3.4: Summary statistics of the normality test for returns of sampled 56
funds
Table 3.5: Ranking of funds based on the Sortino Ratio 57
Table 3.6: Spearman Rank correlation coefficient 58
Chapter IV - Regulatory Constraints And Fund Performance-
Comparing Alternate Regulatory Regimes
Table 4.1: Differences in the Regulatory systems 70
Table 4.2: Sample of funds 75
Table 4.3: Sharpe ratio rankings for sampled funds 77
Table 4.4: Information ratio (IR) rankings for sample funds 79
Table 4.5: Poolability test results for SEBI regulated funds 80
Table 4.6: Hausman Test for SEBI regulated funds 81
Table 4.7: Poolability test results for UTI funds 81
Table 4.8: Average Jensen alpha for funds regulated by SEBI 82
Table 4.9: Average Jensen alpha for UTI funds 83
Table 4.10: Average Assets and Management fees of a pure equity funds 84
Table 4.11: Average Jensen alpha (with average managementtee 85
included) for SEBI regulated funds
Chapter V. Cost Management Fee Regulation and Economies
of Scale
Table 5.1: Descriptive statistics for Equity Funds 92
Table 5.2: Descriptive statistics for debt funds 92
Table 5.3: Cost function and explanatory variables 94
Table 5.4: Time series, cross section averages of (yearly) correlations 95
between variables of interest for equity funds.
Table 5.5: Time series, cross section averages of (yearly) correlations 96
between variables of interest for debt funds.
Table 5.6: Correlated Random Effects - Hausman Test 99
Table 5.7: Regression results without the control variable for equity funds. 99
Table 5.8: Regression results with control variable for equity funds. 99
Table 5.9: Correlated Random Effects - Hausman Test 101
Table 5.10: Regression results without the control variable for debt funds 101
Table 5.11: Regression results with the control variable for debt funds 101
Table 5.12: Time series cross section averages of expense components of 103
equity funds
Table 5.13: Time series cross section averages of expense components of 105
debt funds.
Chapter VI Fund Size and Fund Returns
Table 6.1: Fund style deSCription
Table 6.2: Time Series cross sectional averages and standard-deviations
Table 6.3: Time series averages of the cross sectional correlations between
the various fund characteristics
Table 6.4: Means and standard deviations for the monthly fund returns
Table 6.5: Mutual fund Beta's and constants across different asset classes
with CNX500 as the benchmark index.
Table 6.6: Correlated Random Effects - Hausman test
110
111
112
113
116
117
Table 6.7: Regression of Beta and market adjusted fund perfonnance on 117
fund size and other characteristics over one period lagged
effects
Table 6.8: Regression of market adjusted returns (in bear & bull phases of
the market) on lagged fund size and other fund characteristics.
Table 6.9: Regression of beta adjusted returns (in bear & bull phases of
the market) on lagged fund size and other fund characteristics.
119
119
Chapter I - Introduction
Chart 1.1: Concept of Mutual Funds
Chart 1.2: Organization of Indian mutual funds
Chart 1.3: Types of Mutual Funds
Chapter III - Performance of Equity Funds Using Mean-Variance
And Lower Partial Movement
02
05
06
Chart 3.1 Trends in CNX500 for the sample period. 51
Chart 3.2 Presents a test for normality in distribution of returns for the LlC 55
Tax Plan
Chapter V - Cost Management Fee Regulation and Economies
of Scale
Chart 5.1 Regulatory ceilings for Expense Ratio and Management Fee (as 90
percent of AUM) for equity and equity oriented balanced funds
CHAPTER -I
INTRODUCTION
CHAPTER ONE
INTRODUCTION
1.1. The concept of Mutual Funds
Mutual funds are that collect money from several sources - individuals or
institutions by issuing 'units', invest them on their behalf with predetermined
investment objectives and manage the same all for a fee. They invest the money
across a range of financial instruments falling into two broad categories -
and debt. Individual people and no doubt, can and do invest in equity
and debt instruments by themselves but this requires time and skill on both of which
there are constraints. Mutual funds emerged as professional financial
intermediaries bridging the time and skill constraint. They have a team of skilled
people who identify the right stocks and debt instruments and construct a portfolio
that promises to deliver the best possible 'constrained' returns at the minimum
possible cost. In effect, it involves outsourcing the management of money.
More the benefits of investing in and debt instruments are
supposedly much better if done through mutual funds. This is because of the
following reasons: Firstly, fund managers are more skilled. They are trained to
identify the best investment options and to assess the portfolio on a continual basis;
secondly, they are able to invest in a diversified portfolio consisting of 15-20
different stocks or bonds or a combination of them. For an individual such
diversifICation reduces the risk but can demand a lot of effort and cost. Each
purchase or sale a cost in terms of brokerage or transactional charges such
as demat account fees in India. The need to possibly sell 'poor' stockslbonds and
I
buy 'good' stocksJ bonds demands constant tracking of news and performance of
each company they have invested in. Mutual funds are able to maintain and track a
diversified portfolio on a constant basis wijh lesser costs. This is because of the
pecuniary economies that they enjoy when it comes to trading and other transaction
costs; thirdly, funds also provide good liquidity. An investor can sell her/his mutual
fund investments and receive payment on the same day with minimal transaction
costs as compared to dealing with individual securities, this totals to superior
portfolio returns with minimal cost and better liquidity. This can be represented with
the following flow chart:
Chart 1,1
lund
Securtties
Source: Association of Mutual Funds in India (AMFI)
2
In India one can gain additional benefrt by investing through mutual funds-
tax savings. Investment in certain types of funds such as Equity Linked Tax
Savings Schemes (ELSS) allows for certain amount of income tax benefits.'
1.2. Organization of Mutual Funds in India
Mutual Funds are one form of Collective Investment Vehicles (CIV's) in India. The
other forms being Collective Investment Schemes (CIS's) and Venture Capital
Funds (VCF's).The organization of mutual funds in India (excepting for Unit Trust of
India)2 is dictated by the Securities and Exchange Board of India - SEBI (Mutual
Funds) Regulations, 1996, (henceforth termed as 'regulations'). Bank-owned
mutual funds are also supeNised by the ReseNe Bank of India (RBI). This does not
overlap with SEBl's supeNision. Besides, the Indian Companies Act of 1956 and
Indian Trust Act of 1882 also govem funds.
The SEBI regulations stipulate a three tier structure. The constituents of a
mutual fund include the Sponsors, the Mutual Fund, the Trustees and the Asset
Management Company (AMC).
The Sponsor as an individual or along with another corporate body initiates
the process by approaching the SEBI for registration of a mutual fund. There are
certain eligibility criteria which the sponsor has to fulfill [as laid out in Chapter II,
clause 7 of the regulations). Broadly speaking it requires a sound financial track
record over the past fIVe years, a sound reputation with respect to integriity and a
minimum of 40 percent stake in the AMC by the sponsor. For instance, Tata Mutual
I Section 80 C of the Indian Income Tax Act allows for Income Tax exemptions uplO a maximum of
Rs.lOO,OOO.
2 Unit Trust of India (UTI) is governed by the Government of India UTI Act of 1963
Fund set up in 1995 is sponsored by Tata Sons Limited and Tala Investment
Corporation Lim ited.
3
The Mutual fund is itself set up in the form of a trust under the Indian Trust
Act of 1882. The instrument of the trust is executed by the sponsor in favour of
trustees and is registered under the Indian Registration Act, 1908. The investor
subscribes to the 'units' of the fund and, the collected funds/assets are held by the
trstee for the benefrt of the investor.
The Sponsor then appoints the Trustees, AMC and Custodian [Chapter II,
clause 7 (e), (I), (g) of the regulations]. A Trustee holds the fiduciary responsibility
of protecting the interest of the investor. The trustees themselves are to be of
impeccable personal credentials [Chapter II, clause 16 (2)]. Two thirds of them
have to be independent persons and should not be associated with the sponsors in
any manner'. No employee of the AMC is to be a part of the Trustee. The Trustee
has the duty of ensuring that the AMC carries out its activities in accordance with
the regulations and prevent conflict of interest between the investors and the AMC.
The trustee could be either a group of individuals or a Trust Company. Most funds
prefer a board of trustees. The Trustee for Tala Mutual Fund is Tala Trustee
Company Pvt. Ltd.
The AMC consists of the fund managers who manage the investments
Regulations are laid down [Chapter IV] with regard to their eligibility and obligations.
The AMC takes decisions with respect to investment/sales, computing asset values,
declaring dividend and providing investor information, regularty. An AMC cannot
3 www.tatamutualfund.comlrisk-factors.asp
4 Earlier only 50 percent were required to be independent members. This was amended in 2006 by
the SEBI (mutal funds) (Fifth Amendment) regulations.
act for any other fund. The AMC for Tata mutual fund is Tata Asset Management
Ltd. In addition to the above three principal constijuents there is the custodian
(Chapter IV, clause 26) predominant duties includes stock keeping of securities and
settlement between funds. A custodian can service more than one fund but not a
fund promoted by a sponsor who has 50 percent stake or more in the custodian.
For Tata Mutual Fund, ABN AMRO Bank N.U and Deutche Bank are the
custodians.
Apart form these there are the depositories, transfer agents and distributors
who complete the organizational chain for mutual funds in India.
chart:
The organization of Indian mutual funds is represented in the following flow
Chart 1.2
Sponsors I
The organization conceived as above has ijs emphasis on eliminating moral
hazards that could arise out of post contractual opportunistic behaviour on the part
of fund managers. It aims at ensuring arms length transactions between the
sponsor and the AMC.
5
1.3. Types of Mutual Funds
A mutual fund, say, Tata Mutual Fund, can have several 'funds' [called 'schemes' in
India) under its management. These different funds can be categorized by
structure, investment objective and others. It would be well illustrated by the
following flow chart:
!
I
A. Structure I
! 1
open close Internal
ended ended funds
funds funds
Chart 1.3
Types of Mutual Funds
B. Investment
Objective
! ! !
Growth Income Balanced
funds funds
Exchange
Traded
funds
funds
Tax
saving
funds
Index
funds
Source: Associalion of Mutual Funds in India (AMFJ)
MOnlY
market
fund.
c. Others I
Special
Schemes
Sector
specific
funds
An 'Open end' fund is available for purchase or redemption on continuous
basis at the day's closing Net Asset Value (NAV). This gives liquidity to
investments.
6
A 'Close end' fund is open for investment only during the Initial Public Offer
(IPO) after which the investment is locked in until the maturity date which could be
between 3-7yrs. The investor can, however, sell or buy the shares of the funds on
the stock exchange where the shares are listed.
Interval funds combine the characteristics of both 'open end' funds. They
can be bought or redeemed by the investor at predetermined times, say once in six
or twelve months.
'Growth' oriented funds aim at providing capital appreciation. They tend to
invest primarily in equities.
'Income' funds aim at providing regular income to investors. They generally
invest a major portion of their assets in fixed income earning instruments such as
govemment securities, corporate bonds and money market instruments. Their
retums are determined by fluctuations in interest rates.
A 'Balanced fund' tries to provide both capital appreciation and regular
income. They invest in both equities and fixed income securities. They specify the
maximum equity exposure in the prospectus and is normally 60 percent; of late
other types of balanced funds such as "Asset Allocation funds and 'Arbitrage funds'
have also emerged. Asset allocation funds, such as the Franklin Templeton (FT)
PIE ratio fund, allocate funds to equity or debt depending on the dynamic situation.
They tend to increase exposure to equity during a market downturn and move out
during market peaks. The FT PIE ratio fund uses the market PIE ratio to determine
the degree of equity exposure.
7
Arbitrage funds are funds that try to capitalize on the arbitrage opportunities
that arise out of pricing mismatch of stocks in the equity and derivative (Mures and
options) segments of the stock market (Value Research Inc). They invest
predominantly in equities 'Money Marker. Funds invest only in short term debt
such as call money, treasury bills and commercial paper. In the case of these
funds the Net Asset Value is simply the interest accrued on these investments on a
daily basis. Their NAV does not fall below the initial investment value, unlike bond
funds which are marked to market.
Tax saving funds give an investor tax benefits under section 80 C of the
Income Tax Act. Such funds also termed as Equity Linked Saving Schemes
(ELSS), have a lock in period of three years. By investing in such funds a person
can avail of a maximum of rupees one hundred thousand in tax deductions. ELSSs
are normally diversified equity funds.
Index funds invest in securities of a particular index such as the Bombay
Stock Exchange (BSE) sensex in the same proposition. They provide returns which
are close to that of the benchmark index with similar risks as well. It is a passive
investment approach with lower costs.
Sector specific funds focus their investments on specific sectors which the
fund manager feels would do well. For instance, Franklin FMCG fund invests only
in shares of companies that produce fast moving consumer goods.
Exchange Traded Fund's (ETF) are relatively a new concept in India. Such
funds are essentially index funds that are listed and traded on the stock markets.
There are also commodities ETFs such as Reliance hold ETF.
8
1.4. The Mutual Funds Industry in India
The beginning of mutual funds in India was laid by the enactment of the Unit
Trust of India (UTI) Act in 1963. The objective was to provide investors from the
middle and lower income groups with a route to invest in the equity market. It was
also meant to encourage savings. UTI brought out its first fund, Unit Scheme (US)
64 in 1964. It called an amount of Rs.246.7 millionS. UTI remained a monopoly in
the mutual fund industry till 1987. By then US 64 had grown to Rs.32.69 billion and
the overall asset base of UTI was RS.67.38 billion with 25 different schemes.
In 1987 other public sector banks were allowed to offer mutual funds. The
State Bank of India (SBI) set up the SBI Mutual Fund and Canara Bank Mutual
Fund. Other public sector banks such as Bank of India, Punjab National Bank,
Indian Bank entered the fray by 1990. Two public sector insurance companies -
Life Insurance Corporation of India (LlC) and General Insurance Corporation of
India (GIC) also started their own mutual fund companies. But during this period
only public sector companies were permitted to enter the mutual fund market. The
collective assets under management continued to grow and by the end of 1993 it
was Rs.470 billion with UTI alone accounting for RS.390 billion>' There were 44.7
million investors in mutual funds".
1992-93 saw the beginning of economic reforms in India. The reforms
aimed at reducing government control over the economy and allowing for greater
play for the private sector besides others. In keeping with tihis direction the private
, Mutual Funds in India. 19641994, pp 12
UTI Annual report 198788
7 Mutual Funds in India, 1964-94, UTIICM pp 13
8 Mutual Funds in India, 1%494 pp 13
9
sector was allowed to enter the mutual fund industry in 1993. In keeping with this
direction the private sector was allowed to enter the mutual fund industry in 1993.
In the same year the first mutual fund regulations 1993 SEBI (mutual fund)
Regulations came into being. This was later substituted by a more comprehensive
set of regulations - SEBI (mutual fund) Regulations 1996. However, UTI did not
come under these regulations and continued to be governed under the UTI Act of
1963. By 2003 the total assets under management (AUM) had increased to
Rs.1 ,218 billion w ~ h 33 mutual fund families and 401 funds. UTI alone accounted
for Rs.445 billion of the total AUM
9
.
In 2003 the public sector UTI, which had faced serious problems in the late
90's and again during 2002, was s p l ~ into two entities. One was the specified
undertaking of UTI which managed US 64, assured retum schemes and others
which totaled to Rs.298.4 billion and the other was UTI Mutual Fund Ltd'o. The
latter came under the regulations of SEBI. Since 2003 the mutual fund industry has
also seen a spate of mergers. Hence this period was marked by consolidation. By
March 2007 the total AUM excluding UTI touched Rs.3,591 billion showing a
phenomenal growth of 47 percent year-on-year since 2003". During this period
only Russia and China did better than India w ~ h AUM growth rates of 97 percent
and 67 percent, respectively".
, AMFI
10 AMFI monthly March 2007
" AMFI
12 Indian Asset Management: Achieving Broad Based Growth - Mc Kinsey India
10
1.5. Statement of the Problem
The financial savings of the households in India and the savings of the private
corporate sector form the main source of funds for the mutual fund industry. The
gross financial assets of Indian households increased from Rs.l09.6 billion (10.4
percent of the GOP at CMP) in 1993-94 to Rs.4,176.8 billion (14.85 percent of GOP
at CMP) in 2003-0413. The gross financial assets include currency held, bank and
non-bank deposits, life insurance, provident and pension funds, claims on the
govemment, shares and debentures, investments in Unit Trust of India and the net
trade debt. Bank deposits comprised of 42.83 percent of the total financial assets
and shares and debentures (which include mutual fund investments) forming a
small 1.81 percent (EPW). The total AUM at the end of March 2004, Rs.l,396.16
billion was 4.96 percent of the GOP (CMP). A comparison of India with other
countries is given below:
Table 1.1 Comparative AUM as a percent of GOP (CMP) in 2004
Country AUM in $.Billion
U.S 7,414.4
Brazil 171.6
Korea 121.66
India 29.8
Russia 0.85
Data from Investment Company Institute 2004, fact book
GDP data from IMF world economic outlook databases
%ofGOPCMP
67.5
34.4
20.08
5.2
0.2
The above table shows the vast potential for growth in the mutual funds
industry. A minuscule 5 percent of the GOP (CMP) was invested in mutual funds as
"Economic and political weekly, Oct. 09,2004, pp 4487
11
compared to 67.5 percent in the U.S. The comparison is to show what the growth
potentials are.
In many ways the mutual fund industry can be termed to be still in its
infancy. A SEBI survey of Indian Investors 14 for the period April 01, 1999 to March
31, 2001 revealed the low household penetration rate for mutual funds. The survey
found that 7.4 percent of Indian households (13.7 percent of urban and 3.8 percent
of rural households) had invested in mutual funds. Even among the urban
households most investors were from the largest cities with a population of 5 million
or more. The facts point to a low household penetration rate by mutual funds and
also a very narrow urban bias. For individual investors direct investment in equity
was a risky proposition and an important deterring factor as per the survey. Mutual
funds have potential to offer a safer route to the vast untapped households that still
seem to prefer bank savings. But to use the mutual fund route there are other
concerns which need to be addressed.
Firstly funds have to deliver in terms of performance. Comparisons are
bound to arise particularly between fund return and benchmark indices are to be
expected. Out performing benchmarks with lower costs is an important factor to
attract more savings into mutual funds. Apart from performance there is the issue
of moral hazards. Once a contract has been entered into with the fund house there
are risks of conflicting interests. These risks could be broadly classified into
portfolio selection risks and management process risks. The former involves
'adverse portfolio selection' which contradicts the objective of the fund as
mentioned in the prospectus. This could mean higher risk of the fund portfolio and
l+rhrust on Risk Containment. Opinion, Business Line, 2 ~ October 2000
12
or lower risk-weighted returns. There could also be excessive churning of the
portfolio leading to more expenses that would be deducted from the AUM.
Management process risks involve risks arising due to errors in execution of
transactions losses due to counter-party default. It is to protect investors against
such risks that SEBl's (mutual fund) Regulations of 1993 were framed. The same
was substantially amended in 1996.
Given the growth of the mutual fund industry, it's present and potential
importance as a vehicle of financial saving for Indian households, and the
development of regulations to govern fund behaviour we feel it is important to
assess the role of regulation in adding value for the investor. Have the regulations
ensured due diligence, transparency and sound portfolio selection? Have the
dynamics of the fund industry led to the necessity for change in regulations? Is the
present form of fund performance information dissemination adequate? These are
some of the questions that the present study attempts to answer.
This is sought to be done by examining the ability of regulations to: ensure
proper performance disclosure; better returns from funds; control costs of operation;
prevent excessive management fees and be proactive in tackling new issues.
1.6. Review of Theoretical Studies
A brief outline of the theoretical literature surveyed is presented here to fix the basis
for the study of risk involved in mutual fund returns and the need for regulating
mutual funds.
The study firstly reviews the theOries of regulation. The works of Stigler
(1971) and Posner (1969) discuss the general theoretical approaches to regulation.
\3
The justification of mutual fund regulations stems from asymmetric information
leading to possible investor - manager conflict of interest. To control for such
behaviour in 'public interest' the regulator might seek to use different approaches
including direct price control and or disclosure norms.
The study reviews literature relating to measure of risk in the case of equity
returns. It looks at both the Mean-Variance (M-V) approach and the lower partial
movement (LPM), while the M-V approach assumes that preferences are based
only on the mean returns and the variance of the fund portfolio. It is appropriate
only if the returns are normally distributed. During the 70s a semi variance
measure of risk known as LPM was developed. It gave a better approach towards
measuring the risk-return combination.
Writings on the single factor capital asset pricing model (CAPM) which uses
the M-V approach to risk and aHemative multi-factor models used to measure
portfolio performance are also reviewed. In the process it looks at the efficient
market hypothesis and the theoretical impossibility of earning more returns than an
informationally efficient market.
The study then moves on to theories of regulations and the necessity for the
same to tackle Principal-Agent problems that arise due to information asymmetries.
Regulation ought to be dynamic changing according to market conditions as the
fund industry gets competitive the necessity of regulations might wane. In fact it
might be a bane as regulations have an impact on performance and increase costs.
Posner speaks of the costs of regulations generally.
14
To sum up, the basis of regulating mutual funds appears to be from a public
interest perspective to control hazards to investors arising from mar1<et
imperfections. Further the need to have appropriate risk-reward measures emerges
clearly.
1.7. Review of Empirical Studies
Here, again, a brief outline of the empirical literature surveyed is presented. The
aim is to show the developments in methodology and the gaps in studies
conceming India.
Empirical studies pertaining to mutual fund performance can be grouped
into single factor CAPM which uses a single benchmar1< and multiple factor CAPM.
Some of the predominant single factor CAPM studies were those of Sharpe (1966),
Treynor and Mazuy (1966), Jensen.M (1968). But, Ross (1976) argued that
systematic risk need not be explained by a single factor and that there could be 'K'
factors. Hence the basis for multi factor models for assessing performance.
Several factors such as retum of small cap stocks, large cap stocks, midcap stocks,
growth stocks, value stocks and momentum are included in various studies. For
instance, Fama and French (1993) used multifactor model with the mar1<et retum,
the return of small less big stocks (SMB) and the return of high booklmar1<et, less
low booklmar1<et stocks (HML) as three important factors. Using multiple factors
eliminates the error that arises out of the assumption of homogeneity of assets held
by different portfolios or funds. The multiple factor models recalculate the Jansen
alpha which measured superior performance.
15
Apart from these two broad approaches to performance, empirical worll on
other special factors influencing performance analysis is reviewed. Studies on the
influence of size on performance such as Grinblatt and Titman (1989), Indro et al
(1999) and Chen at al (2003) are some who examine the role of size and
diseconomies of scale/all in the U.S context). The results are however mixed with
no clear consensus on diseconomies of scale. With respect to India there has been
no attempt to study the possibilities of size affecting returns. Another factor which
has been found important is the style of a fund. Sharpe (1992), Grinblatt et al
(1995), and Bogle.J (1998), discuss the role of style. Style describes the asset
class of the portfolio of a fund. This explains a large part of the funds return
variability. Studies evolved from the holdings based style analysis (HBSA) method
(categorization of funds on the basis of average marXet capitalization and average
price-to-eamings of the fund portfolio) to the returns based style analysis (BSA)
classifICation (compares fund returns to returns of a number of selected indexes)
While taking samples of funds for assessing their performance the survivor
bias has to be considered. Funds tend to close or merge with others, at times this
covers up for poor performance. So choosing funds which survive might tend to
bias performance analysis. Several funds in India had been terminated or merged
and hence this factor has to be considered while assessing performance.
Since the overwhelming emphasis of regulations in India is on direct
controls on fees and expenses that are charged to fund, investors' empirical studieS
relating to this issue have been reviewed. In the relationship between fund
expenses and performance Sharpe (1966) and Ippolito (1989) throw up different
conclusions.
16
On the relationship between fund size and expenses or economies of scale
and scope Baumol et al (1989), Rea (1999), Latzko (1998) establish economics of
scale and Baumol also finds economics of scope. The Indian context w ~ h
regulatory caps on fund manager fees and expenses and ~ s impact on constraining
fund expenses has not been dealt with so far.
Studies on Indian mutual fund performance by Sahadevan and Thiropol
Raju (1997) and Sadhak (1997) focus on general trends in the mutual fund
performance, regulation and expenses from 1990-91 to 1996. Their focus was not
on the evolved risk return analysis. Madhu S Panigrahi (1996) and Bijan Roy et al
(2003) have attempted risk-return analysis and using traditional CAPM and
conditional performance evaluation techniques respectively.
The review of empirical literature points out to the role of benchmarks and
style of funds in deciding fund performance. Studies also cover fund behaviour in
terms of management fee and expenses. These help point to the general issues of
focus concerning mutual funds. The Indian studies, it is found, tend to focus on
using evolving techniques to study of fund performance. But there is no attempt to
study the impact of regulations on fund behaviour in terms of expenses, fees and
performance. This gap in Indian studies needs to be seriously considered. It gives
us the motivation for our study. We need to study the past implications of fund
regulations before we go ahead with further changes in the same. Have the costs of
regulations eXCeeded the benefrts? Can we improve regulations to ensure better
governance? Do we notice tendencies of price competition between funds? Do they
deliver more than what regulations demand in terms of cost charged to investors?
These questions provoke our study.
1.8. Objectives of the Study
In the light of the above discussion the specific objectives of the study are as
follows:
~ To examine the performance of actively managed equity funds using the
variance and sem i-variance approaches to risk.
~ To analyze the impact of regulations on performance by comparing funds
under weaker regulations (UTI) and funds under stronger regulations (all other
funds that come under SEBI regulations).
~ To examine the impact of regulations on fund manager fees and overall
expenses and determine if the cost reductions with size are forced by
regulations or due to actual economies of scale.
~ To examine new trends in the mutual fund industry. specifICally, the growth in
size and its impact on performance in different market conditions.
1.9. Analytical Tools
Here, we give a survey of the important general analytical tools used to study
various objectives.
For studying fund performance we first have to compute retums over a
period. The approach in this study is to use monthly returns of funds. The monthly
returns are computed using the Net Asset Values (NAV). The NAV is the value of
the assets under management (AUM) minus the operating expenses, divided by the
18
lumber of shares or u n ~ s of the mutual fund. This value is declared at the end of
each business day.
While measuring performance certain standards have to be maintained.
Among the better known standards is the Global Investment Performance
Standards (GIPS)*. We summarize the most important ones for comparing funds
a) Com paris ions should be over the same period
b) Funds ~ h the same broad objectives should be compared.
c) Fund performance must be calculated in the same manner for all the funds.
d) At least frve years performance or from inception (if later) should be used as
the track record.
Hence to compare funds performance the above standards are maintained
and a Time-Weighted Return (TWR) is used.
(1.1)
NAV
T
., is the fund retum at the beginning of the month and NAV
T
is the fund
return at the end of the month. This is relevant for funds which do not give
dividends or any other periodical benefits. In case any dividends are given they
must be added back to give true comparision.
After using the above method to calculate time series monthly returns data,
the risk is calculated for each sampled fund to arrive at risk weighted returns. Two
approaches are used to calculate risk. The most popular measure is the standard
deviation (0) of retums or volatility of returns.
19
(1.2)
U=
,-,
I-I
Rp is the portfolio or funds retum in month i and R is the average of the
fund's monthly retums. Monthly retums are calculated using (1.1). l' is the number
of months involved in the study. Using the standard deviation measure of risk the
following measures are computed.
a) The Sharpe Ratio (SR)
The Sharpe ratio was developed by Bill Sharpe (1966) to measure risk-
adjusted performance. It is calculated by taking the portfoliolfund retums Rp net of
R, is the risk free rate of retum and dividing it by the standard deviation of the fund
retums. This gives the return above the risk free rate of retum per unit of the risk
involved.
SR = (1.3)
The higher the SR, the better is the fund's return per unit of risk.
b) The Information Ratio (IR)
Here the fund's monthly return Rp are taken net of the selected benchmark
retums. This gives the funds excess returns compared to the benchmark. The
standard deviation of these excess retums (EXR) is called Tracking Error (TE).
Dividing the average EXR by the TE gives us the Information Ratio.
IR= EXR
TE
(1.4)
20
This ratio gives the risk-return generated by the fund manager's ability to
use information to deviate from the benchmark. The higher the IR the better is the
fund.
The above two measures were based on the standard deviation as a
measure of risk. An alternate method of measuring risk is the semi-variance. This
gives us the dispersion of all the returns that fall below a certain acceptable return
say, the risk free rate return.
The Sortino Ratio (SOR), (Sortino, 1991) is a ratio that measures risk-
weighted returns using the downside risk or volatili1y of returns below a certain
minimum acceptable return (MAR). This ratio is give below.

"N . (Rp < Rnrin- R nrin)'

(1.5)
N
While the numerator is similar to the Sharpe ratio the denominator is the
standard deviation of returns below a certain minimum (R
mln
). N is the number of
observations.
For the next objective on relevance of regulations for fund performance we
try to arrive at the regulatory impact on performance through a comparision method.
The performance of funds regulated by 'weak' UTI Act Regulations and those
regulated by 'strong' SEBI regulations are compared. They are compared on the
basis of the Sortino and Information ratios.
We then compare their portfolio selection skills as measured by the Jensen
alpha (Jensen, 1968). This is computed using a single factor CAPM model. The
21
alpha is computed separately for SEBI regulated funds and UTI funds which did not
faqll under SEBI regulations. Since all funds are identical in portfolio (equity
diversified) and objective (growth), they satiSfy the comparability criterion of GIPS.
Limnations of data prevented a study of their possible investment styles. A time
series and cross section data set is used.
(1.6)
Rip! is the return of fund 'I' in the period '1'. R. is the risk free rate return in the
period 'j'. Rm is the monthly market return.
The 'a" gives the average alpha for SEBI regulated or UTI funds depending
on the funds considered for the regression. The Jensen's alpha helps to
understand if the fund is earning returns that justify its risk. If the alpha is positive, ~
gives an indication of superior stock picking skills of the fund manager. Beta (13) is a
measure of the systematic risk or the degree of the variance in the portfolio that can
be explained by the benchmark index. The difference in the alpha of the two fund
groups gives us an indication of the behaviour induced by regulations.
For the third objective which studies the role of regulations in contrOlling
fund operating expenses a log-Iog cost function is used to detect the prevalence of
economies beyond regulatory levels. The data are of unbalanced panel format.
; = 1, ... , N
Lcost. is the log of operating costs of fund 'I' in period 'I'.
Laa. is the log of average assets of fund 'I' in period 'I'.
(1.7)
22
(Iaa)' is the quadratic term that is used to capture economies of scale.
Xi is a vector of fund characteristics that can affect costs. It includes family asset
size (LTAA), total load (TlOAD), turnover (T), and regulatory cost ceiling (RCOST)
as a control variable. Use of log-log form helps us to arrive at elasticity estimates
and also helps us to reduce multicollinearity.
For the last objective on size and performance, first a single factor CAPM
model is used to compute the for funds of different size categories.
(1.8)
The returns of fund belonging to asset class i= 1, .. ,4 for the period 't' is given
by Rip!. The benchmar1< index returns, R
CNX500
is the returns on the National Stock
Exchange CNX500 index. Using the average Ws computed for different asset sizes,
the beta weighted returns are computed.
(1.9)
These beta adjusted returns-SRp. (risk weighted returns) and Rp are then
regressed on fund size controlling for various fund characteristics (styles) the
help of dummy variables. A one period lagged model is used for most variables.
(B R,,) = C + a, LN( aa,,_,) + a,LN(T AA,,-,) + a,jlow,,_, + a.age,,_, + as/load"
+a
6
D
1I1
+&"
LN (aa,.,) is the natural log of asset size of the i"' fund in the previous month, t-l.
(1.10)
23
LN (TAA._,) is the natural log of total family assets of the fund family to which the i"
fund belongs minus the i'" fund's assets.
Other variables include 'flow' (growth in fund size due to net sale of fund
units to investors). age of the fund, total entry and exit load and two dummies that
represent growthlvalue stock orientation (0,) and large cap/midcap funds (0,).
The same process is repeated in a disaggregated manner for fund
performances in bull (returns greater than benchmark index) and bear phases
(returns lesser than the benchmark index). This gives a performance under different
market conditions and its variation with fund size.
1.10. Relevance of the study
The relevance of the study arises from four important factors. First, even though
there are studies which use the single factor CAPM to study performance they fail
to consider comparison of performance under risk measures.
Secondly, the ability of regulations in protecting investors through better
disclosure norms and organizational structures has not been addressed at all.
Such a study can point to the need for regulatory strength if needed.
Thirdly, the ability of regulations in constraining costs needs to be examined
while regulations have capped fund operating expenses it remains to be seen if
these are really constraining or well above what economics of scale and
competition could lead to.
Lastly, studies have not covered the issue of growing size of Mutual funds in
India and the possible negative effects of the same on fund performance.
24
examine need for new ones in the light of changing circumstances.
1.11. Scope of the Study
The primary focuses in terms of performance are the equity diversified funds. The
study of performance and regulation of mutual funds is from the period May 1995 to
October 2007. The study period has been extended to 2007 to incorporate the
study of fund size and its impact on retums. It is a study based on time series and
cross sectional data or panel data. Different objectives have different time periods
of study. For the first objective of altemate approaches to risk, the time period is
from June 2000 to December 2006. This time period is purely to enhance the
sample of open end equity diversified growth (OEG) funds
The second objective which involves examining the role of regulations in
ensuring better performance covers the time period May 1995 to September 2000.
This is because we have two different regulations UTI Act of 1963 and SEBI
Regulations existing simuHaneously during their period. It gives an opportunity to
compare and arrive at conclusions and hence overcome the counter factual
problem of deciding how performance might have been w ~ h weaker regulations.
The third objective covering cost regulations and economics of scale is for
the period April 1999 to March 2007, covering eight fiscal years. The start from
April 1999 is guided by the availability of annual reports to gather disaggregated
cost details. It is extended till March 2007. Firstly, to get complete financial years
and secondly, to get more reliable estimates as n is unbalanced panel data. This
25
study covers the open ended equity (diversified) growth funds and the open ended
medium and long term debt oriented funds.
The fourth objective adds relevance in rapidly changing circumstances such
as size of individual funds and also style of funds. This study covers the period
August 2002 to October 2007 as monthly asset size of funds is available only since
August 2002. It reaches up to October 2007 to enable a minimum of 60 months
data on one month a-lagged basis. This study covers only open ended equity
(diversified) growth funds as these funds witnessed rapid growth during this period.
1.12. Data DeSCription, Sources and Period of Study
The study's main focus for analyzing performance and its variation with alternate
risk measures. style and size are Open Ended Equity Diversified Growth (OEDG)
funds. With respect to the influence of regulations on performance both closed and
open ended equity diversified funds have been considered. For the study on cost
regulations. both OEDG funds and open ended growth debt funds with medium and
long term debt orientation have been considered.
For the first objective, alternate risk approach to fund performance. the time
period taken is June 2000 to December 2006. The sample consists of 28 OEDG
funds from 13 different fund houses. Data on the NAV and the benchmark index
Bombay Stock Exchange (BSE) sensex has been sourced from the data base NAV
India. The 91-day t-bill return is taken as the risk free rate of return uniformly
throughout the study and data are sourced from the Reserve Bank of India (RBI).
For the second objective on regulations and performance the time period
considered is May 1995 to September 2000. A sample of ten equity diversified
26
growth funds. three from UTI and the rest under SEBI regulations have been
chosen. Data on UTI funds have been sourced from UTI. data on JM equity are
from NAV India and for the rest it is from their respective mutual fund websites.
The third objective examining cost regulations and economics of scale the
time period is from April 2000 to March 2007. It involves time series cross section
data or panel data in unbalanced format. It includes both OEDG and debt funds
with the maximum number touching 98 funds in 2002 -2003 and the minimum being
33 in (1999-2000). Data have been sourced from annual reports of mutual funds.
The fourth objective on size. style and returns covers the period August
2002 to October 2007 and the data are sourced from AMFI. Value Research India
and individual mutual funds. It covers OEDG funds. It is of unbalanced panel
format as asset size for two months is unavailable.
1.13. Chapter Scheme of the Study
The present study is organized in seven chapters:
The first chapter provides the background of the study and statement of the
problem. This chapter also includes major researchable issues. objectives.
analytical tools. relevance of the study. scope of the study and the database.
The second chapter presents a detailed review of literature and identifies the
existing research gaps.
In the third chapter, a comparison of Mean-Variance (M-V) and lower partial
movement approach to risk for performance ranking has been carried out. This
helps us to understand the relevance of the widely used M-V measure.
27
~ Regulations and performance are treated in the fourth chapter helping us to
understand if regulations have hampered performance on a comparative basis.
~ The f"dth chapter examines the impact of regulations on the operations costs
charged by funds to the fund investors. It throws light on whether regulatory
cost ceilings are really a constraint and how they can be improved upon.
~ The sixth chapter critically assesses the impact of growing fund size in
differing market conditions after accounting for differing fund styles. It helps to
understand if diseconomies have crept in and whether fund size should be
regulated or left to competition.
~ The concluding seventh chapter presents major findings, limitations, further
scope for study and policy suggestions emerging from the study.
28
CHAPTER -II
REVIEW OF LITERATURE
2.1. Introduction
CHAPTER -II
REVIEW OF LITERATURE
The review of literature is to guide us in the methodologies to be used, estimation
procedures and interpretation of results. This chapter, therefore, focuses on both
theoretical and empirical literature to understand the need for regulation, the fonn of
regulation, approaches to risk and perfonnance assessment for funds and also
estimating cost functions. Mutual funds play a crucial role in reducing risk and
transaction cost while investing in the stock markets. They offer a more efficient
route of investing. In the process of encouraging more investments they help in
realizing true prices of securities. This in tum helps attract investments through the
initial public offer route and unleash the savings of Indian households.
This chapter is divided into two broad sections. The first section reviews
theories of regulation, risk and perfonnance measurement. The second section is
divided into five subsections. The first subsection reviews altemate risk measure
studies. The second subsection examines the various approaches to fund
perfonnance measurement. In the third, we deal with studies relating to economics
of scale in mutual fund expenses. The fourth subsection reviews papers on the
impact of size of assets on mutual fund perfonnance. Given the importance of fund
investment style in detennining fund returns, in the fifth subsection we review
empirical literature on fund style. In the last subsection, we focus on a few important
studies covering the Indian mutual funds.
29
2.2. Theoretical Review
2.2.1. Theories of Regulation
We move from a controlled economy in India to one that is regulated. The line
between control and regulation has to be distinct and, therefore, the basis, extent
and mode of regulation has to be made clear. Regulation essentially seeks to
control price, sale and production decisions of finns such that private interests align
with the larger 'public interest'.
The public interest approach to regulation can be dated back to Arthur
Pigou. Pigou 15 dealt with externalities as a source of market failure. The costs of
negative externalities such as pollution is not internalized reflect true costs.
Markets prove inefficient and hence regulatory control is justified. The purpose of
regulation is to improve public welfare (public interest) by correcting market failures:
Government intervention improves welfare.
Posner (1969) discusses exhaustively the regulating monopolies, although
dealing with the issue of regulating 'natural monopolies' Dr more specifICally
'utilities' refonns questions the traditional basis and of regulating monopolies. The
traditional 'dead weight loss' of monopoly profit maximizing price is questioned. He
maintains that price need not be to maximize short tenn profits. He points out other
managerial objectives which may lead to lower price. Preventing potential entrants
from entering developing good reputation are two such reasons. Besides he
questions the rationale for comparing monopoly pricing with competitive price when
15
The New Pal grave Dictionary of Economics and the Law Vol). pp 271
30
the general industrial tendency is oligopolistic whose prices themselves are
uncertain. He points out that supra competitive profits are themselves an incentive
for the monopolist to contain costs and innovate. Taxing monopoly profits is a far
better anernative to direct regulatory controls for Posner. He dismisses other
effects of monopoly such unresponsive behaviour and inferior quality as likely to
cause loss of profit and lower costs which attracts entry. He emphasis on the
distorlionary effects of rate of retum regulation which lead to inferior services
besides, the problems of regulatory lags. He calls for a regulatory system based on
a cost benefit analysis that includes both direct and indirect costs of regulations.
Stigler (1971) feels that the demand for regulation is not often for 'public
benefit' but rather for the benefit of the industry in question. The states coercive
power allows it to tax, control entry, effect make policies which affect complements
or substitutes or even fix prices. Such powen; can be 'bought' by 'industries in'
return for campaign funds to restrict competition or ensure profrts. Stigler points out
that such regulations are actually welfare-reducing as the benefits ineffICient
policies are possible only because in a democracy voting on each policy is costly
and hence not done and also because not all voters who vote might have an
'interest' in the issue.
Tullock (1975) downplays the need for regulation and believes that the costs
of government failures or regUlatory failures are larger than the cost of market
failures.
The other important reason for market failure and ground for regulation is
that of information asymmetry and bounded rationality. Akerlof (1970) pioneered
Ihe study on information asymmetry and showed how imperfect information would
31
lead to adverse selection and the ultimate collapse of the martlet through low
quality sellers crowding out good quality sellers.
Schwartz and Wilde (1979) deal with the necessity for govemment
intervention in markets with imperfect information. Governments intervene in
markets when the percent of uninformed consumers in the market is sufficient to do
so. But this is expensive and besides one does not know what level of information
is considered adequate for a consumer, besides the focus should be on the martlet
and not the individual. If there exist suffICient number of informed consumers the
firm has every incentive to behave competitively. The guiding variable, they point
out, is whether non-competitive behaviour has occurred in the market. Even then
they suggest providing information is a better method than price control.
A mutual fund investor may be operating with imperfect informational. She
is incapable of observing the fund manager and the effort levels to produce best
retums. It could induce post contractual opportunistic behaviour which opens the
investor to greater risks and lower retums. There is also the possibility of the
investor not comprehending the information related to the mutual fund. Both of
these are grounds for regulatory intervention.
Frank and Mayer (1989) point out that information asymmetries can lead to
organizational failures which include fraud by employees, misutilization of funds,
reckless investments and excessive chuming of portfolio.
Regulation of mutual funds normally cover mandatory disclosure of relevant
information, fixing management fees and expense limits, guidelines for valuing the
32
portfolio and conducting shareholder transactions, control of false and misleading
information, investment norms and corporate governance structure.
2.2.2. Theories of Risk Measurement
The purpose of this section is to identify the alternate approaches to risk. In the
tradnional portfolio models an investor is assumed to maximize expected utility of
the portfolio. This is proposnion of securities such as to minimize risk while holding
the mean return constant at a level. Markowitz (1952) was the first to propose the
mean-variance analysis of portfolio decisions. He discussed the concept of
effICiently diversified portfolios which maximized expected returns for a given
amount of risk measured by variance. In 1959, Markowitz elaborated further and
provided means for calculating efficient portfolios when the means, variances and
covariances of retum of the securities were available.
Tobin (1956) was more interested in the implications for the macro economy
~ n l i k e Markowitz who focused on the rational investor. Tobin used the m ean-
iariance approach to study the choice between safe liquid assets and risk assets.
Tobin points out that the fundamental basis of the M-V approach was that
;ecurities were imperfect substitutes for one another'. In the same article Tobin
;howed that the optimal portfolio for any investor is a combination of the optimal
JOrtfolio of risky assets and a portfolio of risk free securities. This speaks of
nvestors' ability to separate the decision about investment proportions among risky
Issets separate from the decision with respect to investment proportion between
'iskyand risk-free assets. This property is termed as monetary-separation.
33
normally distnbuted. Funner vanance penalIZes nOl omy me PO"5IUIllIY UI yel y ou ..
retums but also the possibility of very high returns. The real investor does not
perceive retums above a certain acceptable minimum as a risk. It is, therefore, the
downside risk that is more important and the true risk.
Markowitz (1959) himself, proposed the 'semi-variance' rather than variance
as a measure of risk as it captured only adverse deviations. Semi variance can
also be described as below-mean target semi variance or in other words returns
below the mean return is taken for measuring risk.
Hogan and Warren (1974) developed a CAPM using a below target semi
variance risk measure also termed as the ES-CAPM. This corrects for the
symmetric distribution approach of the traditional CAPM.
Bawa (1975) generalizes the semi-variance measure of risk to reflect a less
restrictive class of decreasing absolute risk averse utility function know as the
Lower Partial Movement (LPM). The M-V approach was restrictive as it ensured an
optimal portfolio only if the utility function was quadratic.
Bawa and Lindenberg (1977) proved that 'separation' holds for the LPM risk
measure when the target was the risk-free rate (for fixed target). Where variance
measures the expected squared deviation around the mean, LPM's measures the
expected value of the alto power of the deviation below a target (when a > 1). When
a=2, the LPM is also termed as target semi variance (TSV).
Fishbum (1977) introduced the general LPM risk measure setting a=2 to
give the TSV. Since the TSV only punishes returns below the target it fit investor
34
preferences. The induced effICient set of his model was found to satisfy the
stochastic dominance criteria (which consider the whole probability distribution of
retums and not just the M-V a measure). Stochastic dominance is better tor judging
the performance of portfolios, because it does not make any assumptions about the
probability distribution of security retums and is based on a general utility function.
The above literature points to the development in measurement of portfolio.
The LPM with a target return based on a more general utility function appears
better in representing investors' preference on a risk return space.
2.3. Empirical Review
2.3.1. Review of Studies on Mutual Funds perfonnance
This section aims to review literature on mutual fund performance - more
specifically on equity funds. The performance of mutual funds has centered around
the appropriate choice of benchmaril for comparing fund performance and the
appropriate model to be used. Most studies focus on whether fund's have
managed to outperform the benchmaril. But studies have also covered diverse
areas such as persistence in fund performance, marilet timing. and bull and bear
marilet performance. Initial studies on performance such as those by Sharpe.
Treynor and Jensen use the CAPM model with a single benchmaril tor assessing
performance.
Sharpe (1966), was among the earliest to use the CAPM to assess mutual
funds performance. He assumed that expected return E(R.). of a fund and its risk
(0.) are linearly related. This can be explained with the help of the following
equation.
35
RF is the risk free rate and fl is the risk premium. This is based on CAPM
assumptions which include the following".
Zero transactions costs
Assets are infinitely divisible
Absence of personal income tax
Individual cannot affect the price of the stock
I nvestors make their choices solely based on M-V of the portfolio
Unlim ned short sales
Unlimned borrowing and lending at the risk-less rate
Homogeneny of investors in terms of the relevant period and in terms of
what they consider as necessary inputs for the portfolio decision
Sharpe found that funds under performed the Dow Jones index by 40 basis
points. Further better performing funds had lower expense ratios.
According to equation (2.1) an investor who can borrow or lend at the risk
free rate and invest in a portfolio with E(Rp) and Op, can by allocating funds
between the risky and risk-free asset reach the Capital Market Line (CML):
E(R) = RF + lRp';pRF F-
(2.2)
The optimal portfolio is the one which delivers the best reward to variability ratio.
(2.3)
36
Equation 2,3 is also popularly known as the Sharpe Ratio (SR), Sharpe
examined the perfonnance of 34 open end funds for the period 1954-1963 in the
US, His study revealed that the SR measure varied from 0.78 to 0.43, This
variation can be attributed to managerial ability.
Treynor and Mazuy (1966) attempted to study a fund manager's ability to
time the market. They used a quadratic to check for this. The quadratic Traynor-
Mazuy TM model as it is popularly called is as follows:
(2.4)
r pe is the fund excess return over the risk free rate in period t, a, is the
estimated selectivity performance, b, is the portfolios systematic risk. rmt is the
excess return of the market over the risk free rate in period t. b
2
is the indicator of
market timing perfonnance and epe is the residual. A positive value for b
2
is argued
as an indicator of good timing ability as it allows the characteristic line to be
upwardly concave, They found no evidence of this in their study of 57 funds for the
period 1953-1962.
Jensen (1968) was the first to introduce a model that captured fund
performance in relation to a benchmark, The model is again based on the CAPM
and is given as fOllows:
(2.5)
Where R ~ is the expected return of the jth portfolio, R, is the risk free rate of
retum, ~ j is the systematic risk, and R
mt
is the market return all for the time period t
37
(1=1 ......... , N). The constant 'n' is the Jensen's alpha. A positive 'a' indicates an
ability to generate superior stock picking. Using this model Jensen studied 115
funds for the time period 1945-59. A statistically SignifICant number of funds had a
negative alpha and the average alpha was minus 110 basis points.
Both these studies by Sharpe and Jensen seemed to confirm the efficient
market thesis (EMT)'. The EMT believes that since security prices reflect all
available information it is impossible to beat the market through active portfolio
market'. Post expenses active management turns out to be waste of money on
fund management fees and expenses.
In contradiction to these two studies Carlson (1970) calculated the Jensen
alpha and Sharpe ratio for 86 funds over 1948-67. He found an average positive
alpha of 60 baSis points and further found the Sharpe ratio of funds at 0.57 to be
higher than that for the Dow Jones with 0.43. More importantly Carlson funds that
performance measurement is dependent on the fund type the benchmark index and
the time period considered.
Mc Donald (1974) studied the performance of 123 funds using monthly data
for the period 1960-69. His study was based on a CAPM model four measures-
monthly mean excess return; reward-ta-volatility Ratio, Jensen's alpha and reward
to variability ratio were calculated. He concluded that the average fund
performance was not SignifICantly different from the market and given fees and
expenses they were slightly better.
Mains (1977) carried out Jensen's study for 70 of the funds over the same
period. He carried out the study with annual and monthly returns. While annual
38
data gave an average alpha of minus 62 basis points the monthly data gave a
nine basis points. Mains argued that monthly data was more efficient.
These studies show that fund managers do out perform a passive
benchmark index portfolio while several studies also devote to the market timing
ability of funds but these are excluded as they are not the objective in their study.
Importantly these studies also show that performance assessment is dependant
upon the time period, the type of funds studied and more importantly the index for
comparison. Increasingly the single factor CAPM came under criticism.
The single risk factor of the CAPM has led to substantial research and
that a muHifactor model would serve us better.
Roll and Ross (1979) proposed the Arbrrrage Price Theory' as an
aHemative to the single factor CAPM. They found that, between 1962 and 1972,
there were at least four other factors which could explain risk. But their test, they
themselves admitted was a weak one as no economic justifICation could be given
for these factors.
Fama and French (1992, 93) argued that the risks of a portfolio cannot be
captured by a single beta. Portfolio risks are muHi-dimensional for them. When they
studied the US stock returns, for the period 1963-90, they found that the CAPM
beta could not explain the entire return variance. They proposed a three factor
model to better capture the risk. Apart from the market risk they included the Small
cap stock returns -Minus-Big cap stock returns (SMB) factor to capture the 'size
risk' and, also the High-Minus-Low (HML) factor to capture the 'value risk'. They
16 Ross (1916), had analyzed the limitations of the single factor CAPM and proposed the APT.
39
find that historically small cap stocks have delivered better average returns (in the
US market) and hence, can be an important explanatory factor for determining the
sources of performance of a fund. The value risk is captured by taking the
difference between the returns of the high book-ta-market (B/M) stocks minus Low
book-to-market stocks. Here they find that value stocks deliver better returns when
the market corrects for ij's over reaction.
Their model proposed increased the R- square or the explanation for fund
performance compared the single factor CAPM models. This was done by
essentially accounting for the portfolio differences between funds or the style of
funds. The posijive alpha probably due to the style and not necessarily due to
POrtfolio selectivity and hence, for a truer measure of alpha we need these
addijional factors according to them.
Several tests were carried for the Fama-French model. Kothari et al (1995)
find that there is no 'value' effect but certainly a size effect.
We take these factors into account when discussing the impact of size of
fund on retums. But we do not consider the multifactor model proposed by them
rather we use the single factor CAPM but separate the funds on the basis of the
portfolio and use a dummy to capture the differential effects of fund style on fund
alpha.
2.3.2. Review of Empirical Studies on Mutual Fund Costs and Fees
~ h e r e have been several studies on the existence of economies of scale and scope
In the financial sector in general and mutual fund industry in specific.
40
Murray and White (1983), find evidence of both economies of scale and
scope in the British Columbia credit unions and point out that regulation limiting the
growth and diversification of these unions could lead to higher operating costs.
Baumol et al (1989) ,using translog cost functions, find economies of scale present
for mutual fund complexes in the U.S .They however find such economies
weakened when assets per account ( with the assumption that the number of
accounts grow in the same proportion as assets) are taken as hedonic variables.
Further they also find significant economies of scope within the fund complexes
implying that buying into funds which are a part of a large complex should give
more net returns other things remaining the same. Their findings clearly shows that
not all funds can be treated alike regarding the assumption of persistence of
economies of scale as hedonic variables can cause differences.
A study of US funds by Rea, Brian and Reid (1999), for the year 1998
shows, again, strong inverse relationship between operating expense ratios and
asset size of similar funds. Further, funds with asset increases over time have also
shown decreases in expense ratios depending on the extent of increase.
While the presence of economies of scale seems to be the general norm,
Latzko (1998), tries to go beyond this and establish the source of economies of
scale. It could be due to management fee reduction or due to 'other administrative
expenses'H. Economies of scale are found to originate substantially from 'other
administrative expenses'. Though economies of scale were found across the entire
range of asset size, the rapidity of decrease in average costs is found to slow down
t 1 Transaction costs of shareholder services and record keeping.
41
:er a critical asset size prompting one to conclude that smaller funds seem to
derive more marginal benefrts of economies of scale than the larger funds.
The study of fund's economies becomes all the more important in the light of
the fact that fund size could have a negative importance on performance. Chen et
al (2005) show that organizational diseconomies (due to hierarchy costs) " are
particularly pronounced for funds that play small cap stocks.
Regarding price competition amongst funds there exist divergent views.
Elton, Gruber and Busse (2004), find no substantial importance given to even
expenses by investors when choosing S&P index funds. This could be possible in a
time when most funds are performing well thereby causing investors to neglect the
expenses. In a survey conducted by Capon, Fitzsimons, and Prince (1996) only one
fourths of investors give importance to management fees. On the other hand,
Christofferson (2001) shows that money market fund managers have been willing to
be flexible with respect to management fees given the convex relation between
fund inflows and lagged performance. A similar convex relation has been presented
by Chevalier and Ellison (1997) in equity funds.
Brian Reid (2005) points out that small fund's in the U.S, in order to compete with
larger funds which have lower operational average costs, have tended to voluntarily
waive of a portion of their fees. He finds that over 90 percent of new cash flows
went to funds with expenses below the median funds expenses.
1M Chen el aI. describe lhese costs due to fund managing te-am members over.investing in oonvincing their
colleagues of the research behind their stock choice.
42
2.3.3 Empirical Studies on Fund Size and Returns
While there have been a few im portant contributions in the area of size and
performance they are not specifIC to India.
Grinblatt and Sheridan Titman (1989) find no clear trends of decreasing
returns for larger funds in the US between 1974 and 1984.
Perold and Solomon (1991), on the other hand, found diseconomies of scale arising
out of increased price impact of large transactions. Such impact costs are found to
be larger for larger trades by Gallagher and Looi (2003) as well for a sample of
institutions in the Australian markets.
Chen et al (2003), after accounting for various benchmarks find that return
:lee lined with lagged fund size for the period 1962 to 1999 in the US. The main
reasons for this are found to be investments in small illiquid stocks and also
)rganizational diseconomies.
On the contrary, Gallagher and Martin (2005) find no statistically significant
:lifferenee in the returns of large and small funds in Australia.
The opinion among Indian fund managers on the issue of size is diverse.
Some feel that there are ample opportunities for investment while others feel that
nvestment choices are drying up.
Z.3.4. Fund Style and Fund Returns
nvestment styles of mutual funds have an important role to play in determining
'und retums. Some equity funds could choose to invest predominantly in growth
43
stocks. These are stocks that have a high price-to-earning (PIE) ratio and do not
generally pay dividends. Such styles of investment can increase volatility. On the
other hand there is the value style of investment. Funds having the value style tend
to have more exposure to cheap stocks. Such stocks tend to have low PIE ratio
.and yield high dividends. Such stocks are less volatile. AHernatively there is the
large cap, small cap investment style. Fama and French (1992) had pointed out
the tendency of small cap stocks giving better returns than large cap stocks. But
small-cap stocks are also riskier as their prices are more volatile.
Sharpe (1992) explains how a substantial part of the return variability of a
portfolio depends on the distribution of the portfolio across a number of asset
classes. He uses 12 asset classes represented by an appropriate index, to study
the influence of 'Style' on the performance of 395 funds for the period 1985-89. He
employs the quadratic programming methodology to determine funds exposure to
different asset classes. He finds that growth equity finds tend to predominantly
focus on growth stocks.
Grinblatt, Titman and Wermers (1995) analyzed the quarterly holding of 155
mutual funds for the period 1975-1984. Using muHiple cross-sectional regressions
of fund performance on fund characteristics they found that 77 percent of mutual
funds tended to be momentum investors. This meant that funds tended to buy past
winners and sell past losers. Momentum investing gave funds better returns than
contrarian investors and the index.
Bogle (1998) uses the mine box mutual fund rating system. He explains
that US fund style evolved from a homogenous form in the 1970s to amore
heterogeneous form during the 1990s. He very significantly finds that expenses
44
are the prime differentiator between actively managed equity fund returns. Further
he finds that index funds delivered better average risk weighted returns compared
to actively managed equity funds.
The importance of fund style in explaining fund returns cannot be denied.
Indian mutual funds although not as diverse, in terms of style have, in the recent
times, adopted GrowthNalue and Large/Mid or small cap oriented styles. We,
therefore, factor this in our study its impact on mutual fund size and performance.
2,3.5. Empirical studies on Indian Mutual Funds
While empirical studies of mutual funds in India are not comparable to sheer
volume of studies conducted in the US it is picking up with the growth of the
industry and more importantly with the availability of more frequent data.
Sahadevan and Thiripalraju (1997) attempted to compare the performance
of funds using total return, consistency and volatility. They did not attempt to use
any CAPM single or multifactor models. Their study covered private and public
sector mutual funds for the period 1995-96. The benchmark used was the SSE
National Index terms of absolute returns. Out of 32 public sector funds, 11
outperformed the index. In the case of private sector mutual funds time out of the
ten studied outperformed the index. The study of course did not intend to go into
deeper risk return analysis and compared a host of different types of funds to a
Single index.
Panigrahi (1996) in his study of Indian Mutual funds selected a sample of
four growth funds for the time period October 93 to December 95 and divided them
into two periods to capture their performance in boom and bear phases separately.
45
The general conclusion reached was that funds had lesser risk than the market
index, BSE 200 or the RBI ordinary share price index and they delivered near
market returns under normal condijions. He uses a log-log model regressing the
log of (monthly average) of NAV on the log of the market index (monthly tune rates
of growth) to arrive at the R2 or diversification and risk compared to the market.
The study of course, has a very limited objective, sample and time period.
Roy and Deb (2003), use the conditional performance evaluation technique
to study fund timing and performance. They pointed out that the tradition models of
Treynor-Mazuy had shortcomings as they based their assessment on historical
average returns without considering the role of new information and the time
varying element of returns. Taking a sample of 89 funds (consisting of equity
diversified and balanced funds) they test for alpha over the time period January,
1999 to July, 2003. Using lagged information variables they find that the alpha
deteriorates. But their study is weak with poor statistical signifICance.
Indian empirical studies tend to focus on the application of evolving methods
to the study of mutual fund performance. However, to the best of our knowledge,
there have been no studies that tried to deal with the interplay between regulations
and fund behaviour. Issue such as the influence of regulations on performance and
its ability to act as a genuine constraint on expenses are left untouched. This study
makes an attempt to fill this gap.
46
CHAPTER - III
PERFORMANCE OF EQUITY FUNDS USING
VARIANCE AND SEMI-VARIANCE OF RISK
CHAPTER - III
Performance of Equity Funds using Variance and
Semi-Variance of Risk
3.1. Introduction
The need for assessing the perfonnance of mutual funds cannot be over
emphasized. Fund manager's capability of generating better risk-weighted retums
than the comparable benchmark infuses confidence in the minds of the investors. It
encourages savings as people have more variety of savings options rather than the
tradnion bank saving accounts or the more risky and costlier route of investing
directly in the stock markets. The more such savings are used to discover the
optimal price of stocks the easier n is for companies to raise funds through the
equity option.
While assessing performance by which we mean the returns net-expenses
generated by the funds, we focus primarily on the actively managed diversified pure
equity funds. Further, while measuring such performance we deviate from the
widely reported measures (in the Indian context) used to measure performance by
using the lower partial movement to capture better risk weighted performance.
The entire chapter is divided into four parts. The second part is devoted to
_the empirical frame work. Here we discuss the methodology of assessing
performance and risk and also the data. In the third part we give the results and
t
nalySiS. Here we rank funds on the basis of their performance using both
easures of risk and see if the ranking varies significantly. In the last part we
erive our conclusions. The objective of this chapter can be stated as follows:
47
To study the performance of pure equity diversified funds using alternate
measures of risk and to check if they give signifICantly different results in terms
of comparative ranks of funds.
3.2. Empirical framework and Data description
3.2.1. Empirical framework
The monthly returns of funds are computed by using the month beginning
and month end Net Asset Value (NAV) as given below:
TWR =[NAV, -NAV,_I ]XIOO
NAV
H
(3.1)
TWR is the time weighted return NAV,., is the NAV at the beginning of the
month and NAV, is the month end NAV.
On computing absolute returns we then move ahead to find the risk
aSSOCiated with these returns and the consequent risk weighted return. Two
alternate approaches are used here. The first is the more popularly used and
reported measures of Sharpe RatiO and Treynor Index. These measures are based
on the assumption that returns distribution is symmetric and, therefore, the
conclusion that mean-variance of a portfolio is enough to derive the risk-weighted
retums.
The standard deviation of portfolio returns:
(3.2)
48
T is the number of monthly retums over a given time period, Rp is the
arithmetic mean of the returns and Rp is the rnonthly return.
Using the standard deviation as a measure of risk the following risk-
weighted measures are computed
Sharpe Ratio (SR)
Rp-R
(SR) = J
(3,3)
CY
RP
The top five funds have a Sharpe Ratio that ranges frorn 0.35 to 0.38. This
is the average return per month per unit of risk measured by the standard deviation
of the fund portfolio returns, the higher the Sharpe Ratio the better. The Sharpe
Ratio has a signifICant advantage as a measure of relative performance as it is
based on the standard deviation of the funds return and not relative to an index.
When relating performance to an index to arrive at the fund alpha the r-squared has
to be reasonably high. This depends on the index selected and, therefore, the
possibility of wrong index bias.
Treynor Index (TI)
TI = _R.!:...p _-_R.:....F
f3 port/aim
(3.4)
The TI is similar to SR excepting for the fact that it uses beta instead of
standard deviation of the portfolio or fund returns. is the funds beta or the
systematic risk. This ratio gives a funds average excess return per unit of market
risk. This measure is rnore relevant for well diversified portfolios. The Treynor and
49
Sharpe Ratios would be the same if the total risk of the portfolio is the same as the
systematic risk. The Treynor Index is based on the assumption that all
unsystematic risk is diversified completely. If this holds true then the total risk as
measured by the fund returns standard deviation is the same as the systematic risk
as measured by the beta. If these two risks do not converge then we can expect a
different form of ranking.
Rp-R
(SR) = f
(3.5)
(1'RP
In order to check if the ranks based on the Sharpe Ratio. Treynor Index and Sortino
are different we use Spearmans Rank correlation coefficient. This is given by
(3.6)
d;=Y;- X; (difference in ranks)
n=sam pie size
3.2.2. Data
The wider population for our sample consists of the actively managed funds which
were pure equity oriented (100 percent equity) and diversified in portfolios.
The time period considered for this study is September 2000 to December
2006. In total it consists of 76 monthly observations. This period gives us a good
mix of bearish and bullish phases in the stock market. The below chart gives the
time series trends for the index CNX500.
50
..
4000
3500
3000
2500
-3 2000
-=
1500
1000
500
o
Chart 3.1 Trends In CNX500 for the sample period.
CNX 500 trend
..
..
-
- ~ l ' O
.
.
11
.
/1
1.1
/'I
r
II. .IN'
I-SerieS11
/
V
.... ~ /'
~
..
:t
..
.
,
: . ~
-,::.
" . ~
iii ~ iii ~ ~ ~ iii
Dale
The CNX500 shows a bearish trend between September 2000 and May
2003. During this period the index moved in a narrow range before breaking out on
a high growth pattem till the end of the sample period. The CNX 500 is also the
chosen benchmark index as ~ represents almost 93 percent of the market
capijalization of the National Stock Exchange (NSE).
The sampled fund consists of 45 funds. Of these, 29 funds are open end
equijy diversified funds and 16 are equity linked tax saving schemes (ElSS). Tax
savings funds have a lock-in period and are ciose-end funds but are diversified in
portfolio. Table 3.1 gives the list of sampled funds.
51
Table 3.1 Sample of Equity Diversilled Funds
Fund
type Fund
type
1.
Birla advantage fund
ED 24. lie Equity
ED
2.
Birla equity fund
ED 25. Lie growth
ED
3.
Birla sunlife mnc
ED 26. Lie taxplan
ELSS
4.
Birla sunlife tax relief 96
ELSS 27. Magnum tax gain
ELSS
5.
Birla tax plan
ELSS 28. Morgan stanley
ED
6.
Bobelss96
ELSS 29. Principal personal tax saver
ELSS
7.
Bobelss97
ELSS 30. Principal tax savings
ELSS
8.
Can expo
ED 31. Pru icici growth
ED
9.
Banbank equity
ELSS 32. Pru icici power
ED
10. DSPML equity
ED 33. Pru icici tax savings
ELSS
11. DSPML opportunrties
ED 34. Reliance growth fund ED
12. Escorts tax plan
ELSS 35. Reliance vision ED
13. Franklin India bluechip
ED 36. Sahara tax gain ELSS
14. Franklin India prima ED 37. SSI contra fund ED
15. Franklin India prima plus
ED 38. SSI equity fund ED
16. Franklin tax saver
ELSS 39. Sundaram SNP paribas growth ED
17. HDFC capital builder ED 40. Tata growth ED
18. HDFC equrty ED 41. Tata pure equity ED
19. HDFC tax saver ELSS 42. Tata tax saving ELSS
20. HDFC top 200 ED 43. Taurus bonanza exclusive ED
21. Ingvysya select stocks ED 44. Taurus discovery stock ED
22. JM equity ED 45. Taurus starshare ED
23. Kotak 30 ED
ED - EqUIty Dwersified: ELSS Equity Linked Savings Scheme
3.3. Results and Analysis
We first consider the Sharpe Ratio rankings. The table 3.2 provides ranking of fund
performance on the basis of this ratio.
52
Table 3.2 Sharpe Ratio ranking of funda
Rk
Fund Type Sharpe Rk Fund Type Sh.rpe
1.
Reliance vision
ED 0.38 24. Franklin tax saver ELSS 0.25
2.
Reliance growth fund ED 0.37 25. Kotak 30 ED 0.2.5
3.
Franklin India prima ED 0.35
0.24
26. Pru icici growth ED
CNX50
4. HDFC tax saver ELSS 0.35 27.
Bina sun life tax relief
ELSS 0.23
96
5. HDFC equity ED 0.35 28. T ata tax saving ELSS 0.2.3
6. HDFC top 2.00 ED 0.34 29. Magnum tax gain ELSS 0.23
7.
Taurus bonanza exclusive ED 0.33 30. Morgan stanley ED 0.23
8. Franklin India prima plus ED 0.31 31. Taurus starshare ED 0.22
9. Tata growth ED 0.30 32. JM equity ED 0.2.1
10. Pru icici tax savings ELSS 0.30 33. BobELSS96 ELSS 0.20
11. Franklin India bluechip ED 0.29 34. Bina advantage fund ED 0.17
12. Pru icici power ED 0.29 35. Can expo ED 0.17
13. DSPML opportunities ED 0.29 36. Lie growth ED 0.16
14. Tata pure equity ED 0.28 37. Lic equrty ED 0.15
15. SBI contra fund ED 0.28 38. Sahara tax gain ELSS 0.14
16. HDFC capital builder ED 0.28 39. Bina sun life mne ED 0.14
17
Sundaram BNP paribas
ED 0.28 40. Lic taxplan ELSS 0.13
growth
18. Principal tax savings ELSS 0.27 41. Can bank equity ElSS 0.12
19. BobELSS97 ELSS 0.26 42. Taurus discovery stock ED 0.12
20. Escorts tax plan ElSS 0.26 43. SBI equity fund ED
0.10
21 DSPML equity ED 0.26 44. Ingvysya select stocks ED
0.09
22 PrinCipal personal tax saver ELSS 0.26 45. Birta equity fund ED
0.00
23. Bina tax plan ELSS 0.26
ED - EqUity Diversified: ELSS ~ Eqully Linked Savings Scheme
The Sharpe Ratio values range from 0 to 0.38. The top five funds are all
above 0.34. While one can compare funds using the Sharpe Ratio nothing much
can be said about the absolute size. It cannot be said as to whether 0.35 is a good
measure. The higher the Sharpe measures the better. When comparing funds
performance using Sharpe Ratio, with that of the broad based index, the CNX500,
53
we find that 36 funds do better. The Sharpe Ratio for CNX500 is 0.24. 19 funds fail
to give better risk-weighted returns than a passive investment in the index.
Therefore, not all the funds have been able to show that performance was worth the
expenses or management fee paid for fund management. We then consider the
Treynor rankings. The same is given in table 3.3
Table 3.3 Treynor Index Rankings
Rk
Fund
Typo nR Rk Fund Typo nR
1.
Reliance growlh fund
ED 3.34
24.
Morgan stanley
ED 2.01
2.
Reliance vision
ED 3.31
25.
DSPML equity ED 2.00
3.
Franklin India Prima
ED 3.26
26.
Taurus starshare ED 1.98
4.
HDFC tax saver
ELSS 2.93
27.
Franklin tax saver ELSS 1.97
5.
Taurus bonanza exclusive
ED 2.85
28.
Magnum tax gain ElSS 1.96
6
Tata growlh
ED 2.80
29.
Tata tax saving ElSS 1.96
7.
SBI contra fund ED 2.80
30.
Birla sunlife tax relief
ElSS 1.91
96
8.
HDFC equity ED 2.76
31.
Pru icici growlh ED 1.87
9.
HDFC top 200
ED 2.69
32.
JM equity ED 1.75
10.
Pru icici tax savings ElSS 2.56
33.
Birla advantage fund ED 1.52
11 .
HDFC capital builder ED 2.55
34.
Can expo ED 1.46
12.
Franklin India prima plus ED 2.47
35.
Lic growth ED 1.43
13.
Franklin India bluechip ED 2.46
36.
Lic equity ED 1.39
14.
Pru icici power ED 2.37
37.
Birla sun life mnc ED 1.32
15.
BobEquity Linked Savings
ElSS 2.35
38.
Taurus discovery stocl< ED 1.22
Scheme97
16.
Birla tax plan ElSS 2.35
39.
Sahara tax gain ElSS 1.19
17.
Tata pure equity ED 2.31
40.
Lic taxplan ElSS 1.16
18
DSPML opporlunities ED 2.22
41.
Canbank equity ElSS 1.09
19.
Principal tax savings ElSS 2.17
42.
S61 equijy fund ED 0.88
20.
Sundaram 6NP paribas
ED 2.17
43.
Ingvysya select stocl<s ED 0.84
growth
21,
Principal personal tax saver ElSS 2.16
44.
BobEquity Linked
ElSS 0.61
Savin gs Scheme96
22.
Escorts tax plan
ElSS 2:08
45.
Birla equity fund ED 0.15
23.
Kotak 30
ED 2.08
54
The beta weighted returns range from 0.15 to 3.34. The top five funds
under this measure are the same as the top five funds under the Sharpe Ratio
except for Taurus Bonanza Exclusive which displaces HDFC equity at the fifth
place. The bottom fIVe funds, according to the Sharpe and Treynor Index, are qune
different.
The above two measures are based on the symmetry of distribution
assumption. In order to overcome this we consider the Sortino ratio.
Before we do compute the Sortino ratio we present some evidences on the
possibilities of non-symmetrical distribution.
Chart 3.2 presents a test for nonnality in distribution of returns for the LlC Tax Plan
fund
20
Series: LICTP
Sample 2000M09 2006M12
16 Observations 76
Mean 1.224211
12
Median 2.940000
Maximum 17.67000
Minimum -26.47000
8
Std. Dev. 7.958188
Skewress -1.268177
KlXIosis 5.500905
4
Jarque-Bera 40.17744
Probability 0.000000
0
The fund returns are negatively Skewed (-1.27). It also has a positive
Kurtosis of 5.5 which indicates that the returns distribution is leptokurtic. A kurtosis
value above 3 gives a peaked leptokurtic distribution. Importantly, the Jarque bera
PB) test-statistic, a test for normality of distribution indicates a non-normal
distribution. The null hypothesis of this test is HD=normal distribution.
The theoretical JB value at 90 percent confidence level is 4.61 while the
actual is 40.17 and highly signifICant. Thus, the null hypothesis is rejected and we
conclude that the returns are non-normally distributed.
We carry out a similar exercise for all the funds and the summary statistics
are given in table 3.4
Table 3.4 summary statistics of the nonnality test
for returns of sampled funds
Parameters Number of Percent of
fund total
Skewness <0 46 100
Skewness >0 a 0
Kurtosis >3 21 46
Jarque Bera > 4.61 15 33
All funds have a negative skew in their returns and 46 percent of them are
leptokurtic. The Jarque bera statistic gives a SignifICantly higher JB than the
Iheoreticallevels for 33 percent of the funds.
Based on our analysis of the distribution we feel that the use of the Sortino
Ratio would be pertinent to better capture risk-weighted returns.
56
Tabla 3.5 Ranking of funds basad on the Sortino Ratio
Rk
Fund
Type
SR Rk Fund Type SR
1.
HDFC tax saver
ElSS 0.66 24. escorts tax plan ElSS 0.41
2.
reliance growth fund
ED 0.64 25. bobELSS97 ElSS 0.41
3.
HDFC top 200
ED
0.63 26. taurus starshare ED 0.40
4. HDFC equity
ED 0.62 27.
pnncipal personal tax
saver
ElSS 0.39
5. Reliance vision
ED 0.61 28. bir1a sunlife tax relief 96 ElSS 0.36
6. franklin India prima
ED
0.60 29. magnum tax gain ElSS 0.37
7. tata pure equity
ED
0.54 30. bobELSS96 ElSS 0.36
8.
pru icici power
ED
0.54 31. JM equity ED 0.35
9. SBI contra fund
ED
0.54 32. Kotak 30 ED 0.34
10.
DSPML opportunities
ED
0.51 33. Morgan stanley ED 0.31
11.
taurus bonanza exclusive
ED
0.51 34. sahara tax gain ElSS 0.27
12. principal tax savings
ElSS
0.49 35. Bir1a advantage fund ED 0.26
13. franklin India pnma plus
ED
0.49 36. Can expo ED 0.25
14 franklin India bluechip
ED
0.48 37. lie equity ED 0.24
15 HDFC caprtal builder
ED
0.48 38. lie growth ED 0.24
16. pru icici tax savings
ElSS
0.46 39. taurus discovery stock ED 0.20
7.
sundaram BNP paribas
ED 0.48 40. bir1a sun life mnc ED 0.20
growth
8. Bir1a tax plan
ElSS
0.44 41. canbank equity ElSS 0.19
9. tata growth ED
0.44 42. SBI equrty fund ED 0.16
o. pru icici growth ED
0.42 43. ingvysya select stocks ED 0.13
T ata tax saving ElSS 0.41 44. lie taxplan ElSS 0.12
2 franklin tax saver ElSS 0.41 45. Biria equity fund ED 0.01
3. DSPML equity ED 0.41
'5D - Equity Diversified; ELSS - Equity Linked StNings Scheme
Comparing the top five funds on the basis of the Sortino ratio and Sharpe
Ratio we find that there is only one change. HDFC Top 200 funds a place in the top
fIVe for Sortino but not Franklin Prima fund which was top fIVer performer according
to Sharpe Ratio.
Similarly the bottom five also have only one change when both
these rankings are compared.
57
Table 3.6 Spearman Rank correlation coefficient
Sharpe Treynor
Sortino
Ratio Index Ratio
Sharpe Ratio
1
Treynor Index
0.96 1
(0.00)
Sortino Ratio
0.95 0.91 1
(0.00) (0.00)
On studying the rank correlation coefficients we find a very high positive
correlation between the Sharpe Ratio and the Treynor Index and Sortino Ratio.
The correlations are also highly significant. This implies that rankings or relative
performance of the sample funds do not change significantly when we use aHernate
measures of risk.
3.4. Conclusions
In this chapter we set out to assess the performance of funds in terms of simple and
widely used measures, the Sharpe Ratio and Treynor Index what we find is that
almost 42 percent of the funds do not deliver better risk weighted retums when
compared to the broad based CNX500 index. This places a question mark on the
ability of a Significant number of fund managers. The expenses and management
fees are not justified by the retums.
We also set out to examine if using aHemate risk measures as demanded
by non-symmetrical retums distribution, would affect the rankings based on Sharpe,
Treynor and Sortino measures. We find that the ranking are not significantly
different. The use of Sortino measure adds no substantial value to what the Sharpe
Ratio -ives us.
58
CHAPTER-IV
REGULATORY CONSTRAINTS AND FUND
PERFORMANCE - COMPARING ALTERNATE
REGULATORY REGIMES
CHAPTER-IV
REGULATORY CONSTRAINTS AND FUND PERFORMANCE-
COMPARING ALTERNATE REGULATORY REGIMES
4.1. Introduction
The importance of assessing the impact of regulatory constraints on the
performance of mutual funds cannot be underemphasized. Mutual funds need to be
regulated to overcome the investor-manager conflict of interests that might arise.
Such post-contractual opportunistic behaviour can compromise the interest of the
investors and expose them to risks such as poor portfolio selectivity, excessive
churning leading to higher costs, higher portfolio risks than what was indicated in
the offer document and other organizational risks such as delayed settlement of
transactions. Hence, the regulator steps in to over corne such market failures with
the objective of ensuring ideal type market conditions as would have prevailed
under perfectly competitive markets. Given the rapid growth of the mutual fund
industry in terms of the number of fund houses, number of funds and the variety of
funds it is assumed that it approximates a contestabl.e market which Baumol et al
(1982) discussed. So, the need for anticompetitive type of regulations is not
envisioned as necessary.
But, however, regulations are not costless. They involve both a direct
(compliance) cost and indirect (negative impact on performance) cost. Hence, it is
important to understand if regUlators have been excessive in their constraints. It is
diffICult for a regulator to get the exact degree of control to be imposed and hence
the dangers of under or over-regulating are possible. Under-regulation can mean
that the investor is exposed to unexpected risks and over-regulation means that the
59
investor is eXPOsed to lower retums. To get the constraints perfectly right is not the
issue as such precise calculations of regulatory cost-benefit analysis is not easily
done and perhaps not possible. A regulatory regime must aim at getting its
regulations right with minimal error margins.
In this chapter we examine how to possibly capture the impact of
regulations on mutual fund performance. In other words, we are interested in
finding whether regulations have imposed more costs than benefits and, therefore,
compromised retums. Such a process is fraught with the diffICUlty of engaging in
counterfactual questions. One is posed with the problem of understanding what the
possible performance would have been in the absence of regulations. This
presents us with an almost impossible task. But, fortunately, the situation eases up
as we have a comparative perspective possible. During the period 1993 - 2003 we
had two aHemate regulatory regimes for mutual funds 1 . The UTI and its funds
came under the regulations of UTI Act of 1963 and all other mutual funds came
under the SEBI regulations. SEBI regulations were definitely more constraining
than the UTI regulations. Hence, we have a set of funds with stronger regulations
and another with weaker regulations. What we attempt to do here is to compare the
performance of these two sets of funds and examine if their performance differed in
terms of various relevant ratios. To make them comparable only similar funds are
considered. In a competitive market funds cannot exist if they consistently under
perform and hence funds would ordinarily strive to ensure that they deliver retums
which are comparable to their peers. In the case of UTI, it being a public sector
" In January 2003, UTI was split into two fund houses. All assured return schemes and the US-64
were retained with the UTI and the rest of the schemes were transferred to a new fund called UTI
Mutual Fund Pvt. Ltd. The latter came under SEBI Regulations. The coexistence of two separate
I regulatory regimes came to an end with this split.
60
mutual fund with supposed govemment backing, one could argue that the incentive
to perform would probably not be there. But one fails to see the point that the UTI
had become a very popular investment mechanism for millions of investors and that
the govemment could afford to see it under perform only to face political risks. In
act when the most popular fund of UTI, US- 64, began to face performance issues
during the 1990s , they dug deep into their reserves to deliver good retums to their
investors despite not being an assured retums scheme
2o
Such was the pressure to
ensure that investors did not go disappointed. So it would be flippant to assume
that the pubic sector fund house had no incentive to perform. But, at the same time,
the organizational aspirations need not necessarily be realized due to the potential
moral hazards. Being under lesser constraints and weaker disclosure norms the
temptation of getting away with hazardous behaviour is strong. The primary means
of doing this could be through choice of investments based on u ~ e r i o r motives
rather than retums based motives. This should mean poor stock selectivity and
should represent an inferior alpha as compared to funds under stronger SEBI
regulations.
This chapter is divided into three broad parts. The second part, after the
introduction, deals with regulatory constraints under the UTI regulations and SEBI
regulations. After establishing clearly the differences between the two the empirical
framework is discussed. This deals with the data, the methodology and the resuHs.
In the third section conclUSions and recommendations are spelt out.
20 The concept of 'assured return' schemes is strange for mutual funds. It was popular during the
early 1990s before SEBI regulations came into effect. SEB! regulations of 1996 called for such
schemes to guarantee both the capital and the returns. Many funds which assured returns ran into
rough weather. For example Canstar fund of Can bank Mutual Fund (now Canrobeco Mutual Fund)
and GIC Big Value Fund of the General Insurance Company (GIC) Mutual Fund could not deliver
the promised returns. For more on this see SEBI Annual Report 1996-97.
61
4.2. Comparison of the Regulatory structure of SEBI (Regulations) and
UTI Act (1963)
In this chapter we first deal with the regulatory differences between the UTI Act and
the SEBI regulations. We first deal with the UTI Act of 1963 and then proceed to
the SEBI Regulations.
4.2.1. UTI Act of 1963 and its constraints on fund behaviour
UTI was created by an act of the Union government of India and hence is a Union
government undertaking. It came into being on the first of February, 1954, by virtue
of the UTI Act of 1963. The preamble of the Act declares that the objective of the
fund was to promote savings and investment, of the Indian publiC, through
participation in the securities market". The initial capital of the UTI was Rupees 50
million contributed by the Reserve Bank of India (RBI), the State Bank of India
(SBI), the Life Insurance Corporation of India (LlC) and other scheduled banks and
financial institutions. In 1975 the Industrial Development Bank of India (lOBI) took
over the RBI stake and along with it, the rights and responsibilities as well.
22
In
1954 it launched its first 'scheme' or fund called the Unit Scheme - 54 (US-54). It
was intended to be an open end, non-assured income fund with a balanced
portfolio of equity and debt.
In 1993 a three member committee with NVaghul as the Chairman
lxamined the structure of mutual fund regulations. It had recommended that all the
lxisting schemes of the UTI be divided into two categories namely, mutual fund
ype schemes and non-mutual fund type schemes. All mutual fund type schemes
I Verma, page 103
2 Malegam committee report on the UTI.
62
were to have an asset management company and come under SEBI Regulations.
Following these recommendations UTI placed all new schemes, launched after
July, 1994 under SEBI Regulations.
The regulatory structure of UTI can be discussed in terms of its
organizational structure, its investment constraints and its disclosure norms.
In terms of its organizational structure, there was a combination of all the
roles, the sponsor, the manager and the trustee in one body. The board of trustees
was entrusted with the responsibility of superintendence, direction and
management of the affairs of the UTI. Each of the trustees was appointed by the
sponsors themselves with the lOBI, by virtue of being the largest stakeholder,
having the largest number of trustees of four. The RBI appointed one and the
chairman of UTI was appointed by the lOBI in consultation with the Union
government of India. This meant that there was no arms length relationship
between the sponsor, the trustee and the funds manager. The corporate
governance structure did not do much to discourage opportunistic behaviour.
UTI's investment objectives allowed it to borrow to meet dividend repayment
obligations with a limit of 10 percent of the fund's NAV. It could also act like a
lending agency and lend to corporations and cooperative societies engaged in
industrial activities. No schemes of UTI were allowed to invest more than 5 percent
of the NAV in the equity of a specific company and not more than 15 percent in the
securities of a company. UTI could also invest in the securities of an unlisted but
soon to be listed company to the extent of 20 percent of its NAV. New company
investments can go up to 1 0 percent of the securities issued or 30 percent of the
aggregate assets.
63
In tenns of disclosure nonns, UTI had to state the objectives clearly in the
offer document and reveal scheme perfonnance once a year. But most importantly
UTI had no obligation to reveal its portfolio.
UTI had no obligations in tenns of controlling expense ratios but charged no
management fees.
While there are other issues related to the flagship scheme US-54, such as
nondisclosure of the NAV, we shall restrict ourselves to these fundamental
regulatory aspects.
Right away one notices that UTI had neither the corporate governance
structure nor the transparency in tenns of portfolio disclosure to ensure that moral
hazards would be contained. It seemed a perfect recipe for opportunistic activities
through dubious investments. Ghosh (1999) in his review of the Parekh committee
report 23 points out how the portfolio structure of US-64 was substantially altered to
become more equity heavy ( 63:37 equity- debt composition) in 1998 compared to
1986 (21:79) without infonning the investing public. Faced with decreasing returns
from debt UTI had no option but to tum to equity for better returns as the US -64
sought to maintain returns and had been dipping into its reserves to continue
paying dividends unrelated to perfonnance. Trustees had allowed the situation to
deteriorate when they were to be the protectors of investor's interest. The Parekh
committee believed that the dominance of the public sector sponsor nominated
trustees allowed the government to abuse the scheme and use it to support the
government's disinvestment of public sector undertakings. The committee found
2l The Deepak Parekh committee was set up in the wake of the crises which faced the US-64 in 1997-
98. The committee recommended that independent trustees be appointed and that each fund should
have a separate fund manager. For a detailed commentary on the happenings see The Hindu.
Business, January 10,2002.
64
that investment decisions were too concentrated in the hands of the top
management and that there was no independent fund management team.
While these observations were general to UTI, the main focus was the US-
64. These distortions can be attributed primarily to the lack of proper corporate
governance structures and also lack of transparency. Investments were made with
little regard for generating best retums.
4.2.2. SEBI Regulations and its constraints on fund behaviour
SEBI (Mutual Fund) Regulations of 1993 replaced the guidelines issued in 1990 by
the government of India. This in turn, was replaced by a comprehensive set of
regulations in 1996. These regulations laid out the corporate governance structure,
the investment constraints, expense caps and disclosure requirements. The
regulations have undergone continuous revisions as and when weaknesses were
seen.
A person or group of persons (sponsors) interested in setting up a fund has
to apply to the SEBI. The latter, in turn, goes through the credibility of the sponsors
and decides on the registration after certain minimum conditions are fulfilled. The
mutual fund itself is to be constituted in the form of a trust (Indian Trust Act) to be
executed by the trustees in favour of the investors. The trustees themselves are
appointed by the mutual fund and two thirds of them are to be independent not
aSSOCiated with the sponsor in any manner. The trustee members are to be people
of established integrity. The trustee or the sponsor then appoints the AMC. The
AMC itself must have proven track record and reputation for fairness. The tnustees
ensure that the AMC functions in accordance with the interests on the investors
65
and within the framework. of the regulations. Hence, SEBl's regulations create a
corporate governance structure with three distinct arms and further guidelines
ensure arms length transactions between the three.
Funds investment regulations are contained in SEBI regulations schedule
VII. Some of the more important ones are spell out below:
1. No mutual fund under all its schemes should own more than ten per cent of
any company's paid up capital carrying voting rights.
2. Inter-scheme transfers of securities within a fund house are to be done at
market prices and on a spot settlement basis.
3. The initial issue expenses in respect of any scheme may not exceed six per
cent of the funds raised under that scheme.
4. No short sales are permitted.
5. No investments in securities of unlisted companies which are associated
with or part of the sponsors group of companies.
6. No mutual fund scheme shall invest more than 10 per cent of its NAV in the
equity shares or equity related instruments of any company. This limit is
exempted for investments in index fund or sector or industry specific
scheme.
These are some of the investment restrictions and are comparable in some
ways with that of the UTI except that there were no specifIC inter-scheme
transaction specific regulations for the latter. The issue of sponsor related
companies was also not touched by UTI regulations.
In order to contain the expenses that could be charged to the investors
SEBI decided to go in for direct control. These regulations are contained in chapter
66
VII (General obligations) and Schedule X (initial issue expenses). These are briefly
outlined as below:
1. The Asset Management Company is allowed to charge investment and
advisory fees limited to
(i) One and a quarter of one per cent of the weekly average net assets
outstanding in each accounting year for the scheme concerned, as long
as the net assets do not exceed RS.l000 million, and
(ii) One per cent of the excess amount over RS.l000 million, where net
assets so calculated exceed RS.l000 million.
For schemes launched on a no load basis, the asset management company
is allowed an additional management fee not exceeding 1% of the weekly average
net assets outstanding in each financial year.
2. The AMC is allowed to charge initial issue expenses and recurring expenses.
These cover the following expenses.
Marketing and selling expenses including agents commission
Brokerage and transaction cost.
Registrar services for transfer of units sold or redeemed.
Fees and expenses of trustees.
Audit fees.
Custodian fees.
Costs related to investor communication.
Cost of providing account statements and dividend/redemption cheques
and warrants.
Insurance premium paid by the fund.
67
Costs of statutory advertisements (included through an amendment in
January, 1998).
Other costs approved by the board (included through an amendment in
January, 1998)
Besides spelling out the various costs that could be included in the overall
operating expenses which included the advisory or management fee, SEBI also
placed a cap on the same. The operating expense ratio (ER) as a percent of assets
managed is capped in the following manner:
(i) On the first Rs. 1 000 million of the average weekly net assets 2.5%
(ii) On the next RS.3000 million of the average weekly net assets 2.25%
(iii) On the next RS.3000 million of the average weekly net assets 2.0%
(iv) On the balance on the assets 1.75%.
For debt funds such recurring expenses are to be lesser by at least 0.25%
of the weekly average net assets outstanding in each financial year.
Hence SEBI has ventured beyond other regulatory systems across the
globe by placing ceilings on the amount of expenses and fees and not allowing
forces to detennine the same.
What is notable is that the management fee is tied to the asset size. This
could be construed as indirectly related to perfonnance as the asset size of an
open end fund also depends on the relative return generated. We would cali this as
'weak fonn 'of perfonnance related fees. It assumes that fund flow depends on fund
perfonnance. So the Regulations have also provided a carrot to perfonn better. But
SEBI has ventured beyond other regulatory regimes across the globe by placing
68
ceilings on the amount of expenses and fees and has not left the same to
competition.
The schedule X deals with expenses of funds with and without entry and
exrt loads. Mutual funds are allowed 'load' funds or 'no-load' fund or a mixture of
them. For open-ended schemes floated on a 'Ioad' basis, the initial issue expenses
can be amortized over a period not exceeding five years. But if any Issue expenses
are incurred during the life of open-ended schemes they cannot be amortized. If the
fund has no entry load then the AMC is pennitted to charge an additional fee not
exceeding 1 percent of the NAV.
SEBI has also gradually strengthened the disclosure rules for funds. These
are contained again in chapter VII (General Obligations). These obligations require
semi-annual disclosure of portfolio and accounts in a widely circulated English Daily
within one month of the half year ending.
Overall SEBI regulations have tried a mix of better corporate governance
structure, infonnation flow and direct controls over expenses and fees to ensure
that the investor is given a fair deal. These two regulatory regimes are compared in
table 4.1 given below.
69
Table 4.1 - Differences in the Regulatory systems
Regulatory requirements
uri Act SEBI Regulations
Implications if
Followed
Three
tier
structure of No yes Improves due diligence
corporate
governance and reduces moral
Including
lhe sponsor, hazards.
Asset
Management
company and the Truslee
Ceilings
on
management No management yes
Can forcibly reduce
fees and operating costs.
fees and cost costs and especially
ceiling. useful W market lacks
competition.
Investment
constraints on Limits mentioned Limited to 5% maximum Can reduce moral
investment
in a particular but lack internal for a specific company Hazards and ensure
company
checks to ensure and not permitted to belter portfolio
it is fOllowed. keep cash holdings selectivity and returns.
beyond 15 days.
Borrowing
and lending Could borrow and Limited borrowing Can be a problem in
constraints.
lend. permilted. case of heavy
redemptions causing
sales at low prices.
Disclosure norms.
No obligation to Specific company Disclosure of holdings
disclose portfolio. holdings disclosed reduces moral hazards
Initially annually and but can lead to
later semiannually. imitating behavior W
more frequent.
The above differences in regulations lead us to two conclusions. Firstly, UTI
investors have greater risks due arising out of principal - agent problems. The
chances of poor portfolio selectivity and consequently poorer returns are greater
when compared to funds regulated by SEBI regulations. But at the same time UTI
is a non-profrt public sector with no management fees charged and possibly
expenses also being low. These lower expenses could make up for the slack in
performance when the NAV is considered. Further in the case of funds regulated by
SEBI there could be a greater assurance in terms of portfolio selectivity but this
could come at a certain cost. The cost of regulations is both direct and indirect. The
direct costs are the compliance costs. The compliance costs include costs of the
trustee board, shareholder intimations and disclosure costs (personnel, printing and
70
mailing) and SEBI fees
24
The second type of cost is indirect and often ignored.
They involve the possible negative effect of regulatory constraints such as
investment limns and portfolio disclosures. Investment limns reduce flexibility with
respect to profrtability investments. It forces a certain minimum amount of
diversifICation on a fund. For instance, a diversified equity fund has to invest in a
minimum of 10 secumies as no equity investment in a single company can cross 10
percent of the assets. This might sound reasonable enough but never-the-Iess is a
restraint even if a deviation is profrtable for the fund's investors. This also has to be
maintained keeping in mind that different security prices could move in different
directions changing their percent composnien in the portfolio. This requires
constant churning of portfolio and hence additional trading costs. The disclosure of
portfolio also has a cost in that it allows traders to 'front-run'2S the fund. This means
that the traders or other investors can guess fund behaviour through fund flow and
push up the price of securities that the fund intends to buy and push down the price
of those that the fund intends to sell. This reduces the realizable retums of the fund.
It can also be termed as 'free-riding' on the research of the fund by outsiders.
Hence, what we see is that the stronger SEBI regulations benefrt in tenms of
investor security but can have possible costs. Does this regulatory system deliver
better when compared to the weaker regulations of UTI? This is the question that
we seek to answer. In the next section we outline the empirical framework.
14 Payal Malik (20M), in a survey finds that the present SEBI regulations are perceived to be of the
high cost-high benefit type by Mutual Fund managers. She estimates the compliance costs to be an
average of 5.35 percent of the overall operating expenses of the AMC's. It is comparable to the US
but much higher compared to similar markets such as Thailand.
"See Wermers (2001) for a detailed study of the same.
71
4.3. Empirical framework, data description and methodology
4.3.1 Empirical framework
In order to compare the performance of funds we first calculate the monthly retums.
The same has to be done for a minimum of 60 months for a valid risk-return
analysis. Monthly returns are computed using the formula:
returns
NAV
T
- NA V,-I
NAV,_,
(4.1)
Where NAV._. is the month end NAV and NAV._. in the month beginning
NAV, the monthly retums are then used to compute various risk-return ratios. They
are given below.
Sharpe Ratio
(4.2)
Rp is the average fund return. RF is the risk free return. The risk free return
here is taken as the bank interest on one year term deposits. Here the one year
term deposit is used as the risk free rate of interest as the general public did not
have access to treasury bills during this period and public sector banks were
considered risk free. 0" p is the standard deviation of the portfolio. The results of
this will help us to understand the risk-retum performance of various funds.
Information Ratio (IR)
(4.3)
72
Where Rm is the return on the benchmark - in this case the BSE-sensex><'
and 0'" is the standard deviation of the excess return or returns of the portfolio in
excess of the market. This ratio focuses on the risk return generated by the
managers' ability to use information to deviate from the benchmark, the higher the
better. The standard IR measure, however, runs into problems if there are negative
excess returns. Hence, we use an alternate measure called as the 'Modified
Information Ratio' (MIR). This is given as below.
MIR
=
(4.4)
The only change is that the denominator, the standard deviation of the
excess returns, is modified by adding an exponent. The exponent is excess return
divided by the absolute value of the excess return. When the excess return is
positive the standard IR and MIR the same. When excess return is negative, the IR
and MIR can be very different.
Jensen's Alpha
(4.5)
Equation 3.3.1.5 helps us to arrive at the Jensen alpha. The IIp gives the
systematic risk and Op gives the fund managers superior stock picking capability. A
positive alpha indicates a fund manager's superior stock picking talent. This
regression is run once each for the entire SEBI regulated funds together and for
16 The benchmark has been chosen on the basis of the fact that it was the most popular reference
index which funds themselves opted to be compared against. The author acknowledges literature
discussions on the sensitivity of measures to the chosen benchmark and feels the BSE sensex is a self
selected option of funds.
73
UTI funds together in a panel data fonnat. It helps us to arrive at the differences in
the average alpha for funds under SEBI regulation and UTI 1963 regulations.
Existence of opportunistic behavior should resutt in an inferior average alpha for
UTI funds. The following equation gives the panel fonnat of the regression.
(4.6)
This helps us to capture the average alpha or stock picking skills of UTI
funds as compared to the average for the rest. We expect that if there was
opportunistic behavior in stock picking then, the average alpha for UTI funds should
be definitely lesser and possibly even negative. Further, Since UTI charges no
management fee the comparisons might be slightly distorted in its favor. To
compare like-with-like we add a minimum management fee of one percent per
annum for the private funds. This is lesser than the 1.25 percent allowed by SEBI
for the first 1000 million in assets. For monthly returns this works out to an addition
of 1/12 percent. This will give as even truer picture of comparison when it is
compared with the same regression resutts for the SEBI regulated funds.
4.3.2. Data
A sample of ten open end diversified equity funds with growth objective has been
selected. The period of the study is May, 1995 to October, 2000. It gives us 66
monthly returns for each fund which is sufficient for risk weighted returns
comparison. The time period was selected to give us a comparison of funds
perfonnance during the existence of the two different regulatory structures.
The criteria for selection of funds were that they should have started before
1996 for the funds that came under SEBI regulations and for the UTI, the funds
74
should have been started before 1994. This is because all funds of UTI that were
started after 1994 were 'voluntarily' brought under SEBI regulations. Hence these
have been excluded as they would not serve the purpose comparing the impact of
regulations. Further, the term 'voluntary' is a vague concept with no definite
obligations and place such funds neither under SEBI nor under UTI with
definiteness. It was imperative that the funds selected be alike in terms of their
investment objective. They are all alike in terms of investment objective as they
focus on a diversified equity portfolio with a growth objective. The sample size is
however, limited as data availability in a continual manner was a serious constraint.
Most funds reported their NAV on a weekly basis which made issues more
complicated as the NAV's used for monthly return calculations had match in terms
of the dates. NAV data have been sourced from UTI, the database NAV India" and
individual fund house websites. The sample is described in the following table.
Table 4.2 - Sample of funds
Fund Fund House
Inception
1. Master Gain
UTI
April 1992
2. Master Growth
UTI
February 1993
3. Master Plus
UTI
December 1991
4. HDFC Prudence' HDFC
February . 1994
5. HDFC Capital Builder'
HDFC
January 1994
6. HDFC Equity' HDFC
December 1994
7. Franklin Blue Chip"
Franklin Templeton
November 1993
8. Franklin Prima"
Franklin Templeton
November 1993
9. Franklin Prima Plus"
Franklin Templeton
September 1994
10. JM Equity
JM
December 1994
All these funds W9f9 initially a part of 2d" Century Asset Management Company
taken owr by Zurich India Mutual Fund. Zurich India was itself taken over by HDFC
Mutual Fund in 2003
" The database NA V Indian is mutual funds specific database which is venture of Capital Market
Limited.
75
-
These funds we'" taken over from Pioneer ITf Mutual Fund by F"'nlcHn Templeton
mutual fund in 2002.
Data for UTI is sourced from UTI. Data for Franklin Templeton funds is sourced
from the Funds website and for other funds data is from /olAV India data bass.
The sample contains three funds of UTI, three of HDFC taken over from
Zurich, three from Franklin Templeton taken over from Pioneer ITI mutual fund and
one from JM fund house. In total, we have ten funds selected from four fund
houses.
Very consciously the flagship fund of UTI, US-64 has not been chosen in
the sample. This fund is an income fund and was the subject of intense controversy
when ~ collapsed in the late 1990s. It was probably the best example for
demonstrating moral hazards due to poor transparency or information disclosure.
But, at the same time, this fund was also most abused by the government to induce
deliberate interventions in the market and also support government public sector
disinvestments. This fund is there avoided as ~ is not a pure equity fund and
secondly its portfolio distortions are not entirely due to internal opportunistic
behaviour but due to extemal constraints in the form of govemment coercion.
4.4. Results and AnalYSis
We start by taking the performance of funds in terms of the equations which define
Sharpe ratio, Information ratio and Jensen's alpha and then rank the funds in terms
of each measure. These results are given in the table 4.3 with explanations
following.
76
Table 4.3 - Sharpe ratio rankings for sampled funds
Rank Fund Name
(rp - r
f
)
Up Sharpe Ratio
1 Franklin Prima plus 1.06 9.12 0.12
2 Franklin Blue Chip 0.96 8.59 0.11
3 HDFC Equity 0.79 8.22 0.09
4 HDFC Prudence 0.39 4.9 0.08
5 Master plus 0.14 7.53 0.02
6 Franklin Prima 0.17 10.62 0.02
7 Index -0.01 8.64 -0.001
8 Master growth -0.1 8.09 -0.01
9 JM equity -0.14 9.34 -0.02
10 HDFC capital builder -0.15 7.52 -0.02
11 Master gain -0.43 7.66 -0.06
All computatIons by the authors
Among the funds we see that two of UTI funds have negative Sharpe ratio
which indicates that the return per unit of risk defined as standard deviation of the
fund returns is negative. Two other private sector funds regulated by SEBI also
demonstrate such negative Sharpe ratios. These four with negative Sharpe ratios
also have a lower ranking than the index. This demonstrates that a passive
investment in the index would have delivered superior returns.
While all other private sector funds have demonstrated positive returns per
unit of risk one from the UTI stable - Master plus fund joins them. This fund has a
rank of 5 with a very small Sharpe ratio of 0.02. There can be nothing extremely
positive that can be said about UTI funds in terms of this measure. While giving
77
these ranks one has to keep in mind that UTI had substantially lower expense
ratios (ER) as compared to all other funds. This meant that the deductions from the
unn asset value in terms of expenses would be smaller as compared to other funds.
The ER of UTI is lower due to two reasons. Firstly, due to the possible economies
of scale that ~ enjoyed as it was substantially larger than all other funds. Secondly,
UTI did not charge management fees as compared to the 1 .25 - 1 percent charged
by other funds. In fact, UTI cross subsidized the expenses of some domestic funds
such as US-64 through the earnings/fees generated by its funds meant for non-
Indians. The hypothesis that UTI enjoyed economies of scale is untested but it
certainly did not charge management fees which gave it an edge in terms of
performance after expenses were deducted. So the performance of UTI funds
appears all the more unimpressive.
Table 4.4 gives us the IR and MIR rankings. Since IR gives the returns of a
fund as compared to a benchmark (excess return) per unit of tracking error
(standard deviation of the excess return) it is different from the Sharpe ratio which
gives returns in excess of the risk free return divided by the portfolio returns
standard deviation. The MIR is also calculated to avoid errors which might creep in
due to negative excess return.
78
Table 4.4 - Infonnation ratio (IR) rankings for sample funds
Rank
Name
R" CT"
IR MIR
1
Franklin Prima plus
1.07 9.12 0.12 0.12
2
Franklin Blue Chip
0.97 B.59 0.11 0.11
3
HDFC EqUity
0.8 8.22 0.09 0.09
4
HDFC Prudence
0.4 4.9 0.08 0.08
5
Master plus
0.15 7.53 0.02 0.02
6
Franklin Prima
0.18 10.62 0.02 0.02
7
Master gain
-0.43 7.66 -0.05 -27.99
8
HDFC capijal bUilder
-0.14 7.52 -0.02 -33.40
9
Master growth
-0.09 8.09 -0.01 -36.18
10
JM equity
-0.13 9.34 -0.02 -41.66
All calcu
lations by the authors
The rankings of funds in terms of I R are the same as that for the Sharpe
ratio. But once we use the MIR the ran kings change for funds with negative excess
returns. But overall it is the same story for UTI funds. The IR or the MIR give us the
return tQ the risk taken by the fund manager for deviating from the market risk or iI
is the riSk-return for only the fund managers selectivity skills and not for the returns
due the general market movement. In this case Master plus is the only UTI fund to
shOW a positive return for the fund manager's selectivity skills but is a very small
0.02. The other two funds of UTI have negative returns to show for deviating from
the martel. Two other private sector funds also show negative MIR. A fund house
like UTI ought to demonstrate better selectivity skills given iIs considerable
experience in the Indian markets. But the new come private funds have done
better. It is difficult to accept that this is due to inferior management and only raises
79
doubts lack of transparency leading to stock selection not based on maximizing
retums.
In order to carTY out the empirical analysis, we first need to test for poolabilty
of data. The pool ability test which uses the F- statistic is carried out for both the
fund groups separately.
The F- statistic is computed as below.
F=(S,-S\)/[(n-l)(K+l)] _ F[(n-I)(K+l),n(T-K-I)] (4.7)
S\ l[nT -n(K + I)]
8
3
-8, is the difference between the collective residual sum of squares and
the sum of all individual regressions residual sum of squares. N is the number of
cross sections. T is total number of observations and k is the number of regressors.
This test aims to see if there is any difference between the slope coefficient
of the cross sections. The null hypothesis is that the slope coefficients are the same
for all.
Table 4.5 - Poolabiltly test results for SEBI regulated funds
53
15513.79
5, 14551.66
N 7
K 2
T 448
5
3
-5, 962.1319
nr 53.45177
dr 4.67148
F 11.44215
80
The Ho is rejected at 5% level of signifICance as the tabulated F(18,3115) = 1.61.
The calculated F > tabulated F. The test shows that the F-stat is SignifICant or the
data is not poolable. Hence we go in for the Hausman specification test to establish
whether we need to go in for a fixed effects or a random effects model.
Table 4.6 - Hausman Test for SEBI regulated funds
Variable Coefficients
(fixed)
0.708
chi2(1) - 0.00. Prob>chi2 = 1.0000
Coefficient
(random)
0.708
Difference
5.55e-16
Standard
error
0.0028
The Hausman specifICation test shows that the model is a random effect
model. The null hypothesis, Ho, is random effect and it is not rejected in this test at
5% level of significance.we similarly carry out the poolability test for UTI funds. This
is given as below.
Table 4.7 - Poolability Test for UTI Funds
s3 4370.355
sl 4356.656
N 3
K 2
t 192
s3-s1 13.69893
nr 2.283155
dr 7.683697
F 0.297143
The Ho is not rejected at 5% level of signifICance. The tabulated F(6,567)= 2.12. So
calculated F< tabulated F. The test is showing that the F-stat is insignificant or the
data is poolable. Hence in this case we go in for OL5 pooled regression.
81
We next move on to computing the average Jensen alpha for the two set of
funds using equation 4.7 for each separately. We use a random effects model for
SEBI regulated funds and a OLS model for UTI funds. Table 4.9 gives us the
results for funds regulated by SEBI.
Table 4.8 - Average Jensen alpha for funds regulated by SEBI
Variable
C
B
Coefficient
0.45
0.71
Adjusted R-squamd 0.52
Std-error
0.27
0.03
t .. tatistic
1.60
21.8
Probability
0.10
0.00
Table 4.8 gives us a positive alpha of 0.45 Significant at the ten percent
levels. This means that SEBI regulated funds have an average positive stock
selection skills. The beta is 0.71 which shows the degree to which their retums are
explained by the chosen benchmark. Their deviation from the index through
altemate stock composition shows positive rewards. In a competitive market funds
are constrained to spend money on research to identify stocks that could deliver
better returns than the index. Such performance is rewarded by investor through
further inflows of money/investment into the open end equity fund. Enhancing the
assets managed in tum is an incentive for the fund manager as the management
fee is fixed as percent of the same, higher the assets larger the absolute fee.
Though there was no use of performance based fees during this period the fact that
absolute fees were linked to asset size and that there was no indexing of the fees in
any manner to inflation would itself to a strong incentive to enhance performance.
The manager's interests are therefore inter-twined with that of the investors. This is
proven by the average positive alpha.
82
Table 4.9 - Average Jensen alpha for UTI funds
Variable
c
Coefficient
-0.12
0.71
Adjusted R-squared 0.62
Std-error
0.35
0.04
t .. tatl.tlc
-0.36
17.49
Probability
0.72
0.00
Table 4.9 gives the results for UTI funds. Our hypothesis of inferior stock
selectivity is borne true by an average alpha which has a negative sign (as
expected) but is not signifICant. The low significance part could be due to the small
sample. But even with this small sample we have no signifICant tock selectivity
skills demonstrated. The average beta of 0.71 shows that the UTI funds did not
have the same risk as the index, but their deviation from the index composition has
not been met with any reward. This leads us to the issue of possible clash of
interests and opportunistic behaviour. It could be argued that this lack of stock
selection skills is due to purely bad decisions made in good faith or, in other words,
the fund manager is inefficient. If this were the case then one might have expected
change in fund managers. UTI had no specific manager, though they continued
despite poor performance. But poor selectivity and good faith is hard to accept
when you expect a fund manager in UTI to have considerable experience and, .
therefore, better knowledge of Indian companies and potential good stocks as
compared to newer fund houses. We would prefer to conclude that the difference
in alpha is due choice of portfolio-a portfolio the fund did not have to disclose based
on signifICant 'self-interest' and not 'investor-interest'. The difference in the alpha of
0.45 may contain some element of misjudgment as well but is too large.
83
The comparison so far has been between UTI funds, which charged no
management fee, and the SEBI regulated funds which were allowed to charge
management fees between 1 and 1.25 percent of AUM. Therefore, our comparison,
so far, would tend to bias the results in favour of UTI funds. The NAV of SEBI
regulated funds would be lesser by the extent of the management fee, whereas,
UTI funds operated on a non-profit motive. In fact the US-64 was cross-subsidized
by income earned from floated for non-Indian citizens. Such being the case, we
think it might be pertinent to add back the management fee to the return of other
funds and compare the results again. But this involved certain difflCuHies. Data on
actual management fees charged were not available for these funds. The only
aHernative was to usae an average for the industry. The Mutual Fund Yearbook
2

gives us aggregate data with respect to expense categories and asset size for pure
equity funds. From this it was possible to calculate the average percent of
management fees charged by the SEBI regulated pure equity funds. Table 4.10
gives these numbers.
Table 4.10 - Average Assets and Management fees ofa pure equity funds
1996 1997 1998 1999 2000
Assets Size
(Rs.Miliions) 496883 394899 395019 487253 91108
Management Fee
(Rs.Miliions) 5783 4639 4353 3985 6724
Management Fee
(% of assets) 1.14 1.17 1.09 0.8 0.74
All computations by the authors
21 The Mutual Fund Yearbook is a joint publication of Association of Mutual Funds of India (AMFI)
and UTI Institute for Capital Markets (UTIICM). It contains aggregative data pertaining to assets,
income and, expenditure of di fferent categories of funds.
84
From the above table we get an average management fee of 0.97 or close
to 1 percent of the assets. We divide this by 12 and add the resultant to each
monthly retum of the private funds. Using these retums we then run regression 4.8
again.
Table 4.11 Average Jensen alpha (with average management fee included)
for SEBI regulated funds
Variable
Coefficient
Std-error t..atatistic Probability
c
0.53 0.26 1.9 0.05
0.71
0.03 21.79 0.00
Adjusted squared 0.62
Table 4.11 gives us the new results for private SEBI regulated funds with
the management fee added to returns. We, obviously, get a higher alpha of 0.53
and also now signifICant at the five percent levels. These results help to further
consolidate our hypothesis that SEBI regulated funds had a better incentive to
ensure due diligence in portfolio selection and hence, perform better.
4.5 Chapter Summary
This chapter set out to examine if SEBI regulations were too costly in terms
of direct and indirect costs of regulations. Too costly here is implied to mean that
the net benefits of preventing fraud on the investor through self interested
opportunistiC portfolio selection were less than the costs. This was sought to be
studied by comparing them w ~ h a set of UTI funds which did not have the sort of
regulations that encourages due diligence or prevents opportunistic behaviour.
85
Our findings show that regulations have delivered in terms of ensuring far
superior selectivity skills in portfolio and hence also return. For SEBI regulated
funds the average Jensen alpha is 0.45 without adding management fee back to
the returns. With the management fee included, the Jensen alpha is higher at 0.53.
For UTI funds the average Jensen alpha is negative but not significant. On an
average, we could say that regulations can take substantial credit for the average
0.45 to 0.53 higher selectivity skills. A combination of incenlivising management
fee tied to asset size) and disclosure norms on the part of SEBI regulations and
competition between funds can stake claim to this. The net benefit of regulations
can be said to be positive.
To go further, we feel regulatory disclosure can be made more periodical
given its benefits. At present portfolios are disclosed twice a year. This still provides
for substantial leeway in terms of hazardous portfolio selection which in tum can
compromise on the risk level of the fund and also the return. Besides, we also feel
that the Regulations need to move away from the 'weak form' of performance fees
to a more stronger form. There is no certainty that fund flows are primarily driven by
relative performance. In fact marketing expenses could influence the investor's
choice more than the relative performance. The move to a 'stronger form'
performance fee has to aHematives. The choice is either a symmetric or fulcrum fee
as allowed in the US or a non-symmetric fee. The literature on this is divided there
is no clear indication as to which is better. From a gradualist perspective SEBI
could start with a non-symmetric fee which has a base fee lower than the present
levels and a performance fee that rewards good relative performance. Relative
performance can be measured with respect to the benchmark index that the fUnd
opts for com parison in its offer document.
86
CHAPTER-V
COST - llANAGEMENT FEE REGULATION AND
ECONOMICS OF SCALE
CHAPTER-V
Cost- Management Fee Regulation and Economies of Scale
5.1. Introduction
In this chapter we examine the direct regulations of expenses of mutual funds. The
manner in which the operating expenses or expense ratio (ER) and management
fees are capped by SEBI regulations has already been outlined in Chapter 4.
SEBI has ventured beyond other regulatory regimes for mutual funds in
specifying the percentage limits for ER and management fees. SEBl's i m p l i c ~
assumption appears to be that left to the market mutual funds would tend to
overcharge the investor in terms of expenses and fees charged for services. This is
possible in a market which lacks competition or lacks a strong competition law to
restrain anticompetitive behaviour. In the initial phases of regulation, when the
mutual fund market was in ~ s infancy, it was probably the right thing to do. What is
interesting about SEBl's regulation of cost is that it places a progressively lower
ceiling as the asset size increases. Again this seems to be based on the i m p l i c ~
assumption that mutual funds would have economics of scale and therefore a
progressively lower average expense ceiling is viable. In trying to set ceilings SEBI
risks two types of errors. Firstly, the ceiling could be too high, therefore, it could
allow funds to charge higher than needed. Secondly it could be too less prompting
funds to either sacrifICe their fees to cover expenses or resort to means of cutting
costs in manners which could affect returns, which might be detrimental to the
investors. For instance a fund might decide to cut back on research expenses.
87
As the size of a fund increases economies of scale in administration
expenses is possible. The benefits of lower average costs would be passed on to
shareholders in an industry that is competitive. This would lower expense ratios.
For fund complexes with a large number of funds, there could be further economies
possible in sharing of research expenses, general advertisement expenses and
marketing infrastructure expenses. Since fund managers derive their profrts from
management fees they would certainly strive to increase the asset size under their
management. For this they have to compete with other funds for investor's pool of
savings. It is possible that funds might also decrease their management fees
voluntarily to attract more funds. Theoretically, this is viable up to the point where
the marginal benefrt of fee reduction (in tenns of asset increase) is equal to the
marginal cost (reduction in total fees). Reduction in fees WOUld, however depend on
investor preferences between price and non-price factors in choosing funds to
invest in. Non-price competition through product diversifICation, advertisements and
after sales services can help to reduce elasticity of demand with respect to fees.
But given that most services are mandatory, price competition may still be
important.
The fund industry has grown substantially in tenns of the number of funds,
variety of funds and also number of fund houses. The number of fund complexes
has risen from 10 to 29 during 1993 - 2006, with a total of 449 funds and 55 new
funds added in 2005 - 2006
29
The types of funds have also been getting
increasingly diverse trying to cater to the risk profile of potential clients. This in itself
can be a pointer to increasing competition in the mutual fund industry and,
therefore, if there are any greater economies one would expect funds to lower ER
29 Figures sourced from Association of Mutual Funds of India (AMFI) monthly, March 2006.
88
for investors. Further compe@on can also induce lower ER through lower
management fees even while keeping other expenses at the regulatory level.
This chapter has two objectives.
First it intends to compare cost regulations with actual costs and see if
there are greater economies of scale greater than what SEBI assumes
for funds.
Next, it also aims to see if funds compete in terms of price (management
fee).
This chapter is divided into five parts. In the second part we quickly outline
the regulations and proceed to the empirical outline in the third. In the fourth part we
present the results and analysis. The summary and conclusion is provided in the
last part.
5.2. Regulation of costs and management fees
In administering the funds, vested with them by investors, mutual funds incur
operating expenses (ER). These expenses are deducted from the assets and
therefore, are crucial in determining net returns to investors. The regulatory
authority, Securities and Exchange Board of India (SEBI)30, has placed limits on the
ER that can be incurred and any excess expense has to be made good by the fund
sponsors without affecting the investors.
One of the most important components of operating expense is the
management fee. The management fee has been capped and the cap varies for
asset size. For instance all funds can charge a fee of 1.25 percent up to one billion
lO Clause 52, chapter VII , SEBI Mutual Funds (Regulations) Act of 1996.
89
rupees in weekly average assets and 1 percent on assets beyond this level.
Perfonnance based fees are not common and at the point of writing there was only
one fund which had such a fee" .
The other operating expenses include expenses on marketing and selling,
brokerage, investor communication, registrar services, trustee fee, audit fee,
custodian charges, and SEBI fees. The overall expenses (including management
fees) are also capped and cannot exceed 2.5 percent for the first one billion Indian
rupees, 2.25 percent for the next 3 billion, 2 percent for the next 3 billion and for the
balance 1.75 percent for all equity funds .This limn in itself would cause the average
expenses to decline as asset size increases. For funds investing in fixed returns
securities the expense ratio has to be lesser by 0.25 percent at all levels. Expenses
in excess of those fixed by regulations have to be borne by the sponsor. chart 5.1
gives a graphic description of the regulatory ceilings for equity, debt and index
funds.
Chart 5.1 Regulatory ceilings for Expense Ratio and Management Fee (as percent of
AUM) for equity and equity oriented balanced funds
Regulatory ceilings for Expense ratio and
Management Fee (as a percent of assets)
I Sahara Wealth plus Fund was launched in July 2005. It offers a variable pricing option which
Ipmds on whether the net portfol io returns is above zero and greater than the benchmark.
90
5.3. Empirical framework, Data description and Methodology
5.3.1. Data
The time period considered is April, 2000 (financial year 2000-01) to March, 2007
(financial year 2006-07) giving a total of seven years. Data on the relevant variables
such as expense ratios, management fees, marketing expenses, turnover, have all
been primarily sourced from the annual reports of various fund complexes. The
data is unbalanced for reasons of lack of access to continuous reports. lack of
complete information in some annual reports and also because some funds started
after 2000 and some funds were terminated before March, 2007.
The selection of equity funds was based on SEBI regulations for expenses.
For actively managed funds since equity funds and balanced funds were permitted
the same expense levels, open ended diversified equity funds and equity oriented
(more than sixty percent of their assets in equity) balanced funds were chosen as
the target population. Tax saving equity funds were not included as they are close
ended funds with expenses in the first three years being inflated to cover initial
issue charges. Similarly index funds have also not been included as they do not faU
under "actively managed" funds criteria.
The choice of funds has been random but restricted to those with an
existence of at least three years .Only full years of operation were considered and
funds which started mid year or were terminated mid year were excluded as their
annualized costs would not reflect what actual expenses could have been (say due
to waiver of management fee).
91
Similarly for debt funds, long term and medium term debt funds have been
considered with the sample again depending on a minimum of three years of
existence for the fund and also availability of data.
The sampled funds, their number and average assets, across the years considered
are given below.
Table 5.1: Descriptive statistics for Equity Funds
Yea.
1999_
2000-01 2001-02
2000
2002-03 2003-04 2004-05 2005-05 2005-07
No.
21
39
53 74 73 69 67 69
AA"
1471.62
1377.4 925.5 822.7 1362.8
2265 2990 5038.8
(1388.4)
(1777.5) (1235.5) (951.7) (1779.9)
(345) (4241.4) (6974.9)
Asset size is in Rupees mil/;ons. Figures in parentheses ore standard devlOlicms.
Table 5.1 shows the average assets for equity funds and the average
number of funds that were sampled across the time period. Average asset
size has shown a significant increase since 2004 ever since the Indian stock
markets entered into a bullish phase. The standard deviations (in
parenthesis) show that the spread of fund in terms of size has also tended to
increase similarly.
Table 5.2: Descriptive statistics for debt funds
VH. 2000 2001 2002 2003 2004 2005 2006 ZOO7
No. 11 16 17 24 23 24 23 24
4687 5084.8 7005 10882 10402.7
4585.9 2028 1411.6
.
AA
(3792.7) (1643) (1315.9)
(4912.9) (5243.7) (7268) (14578) (11676.6)
.. Average asset see in Rupees millions. Figures in parentheses are standard deviations
92
Table 5.2 shows the average assets (standard deviation) and number of
funds in the debt category. The size of debt on an average is much larger than that
for equity funds. Interestingly the average debt fund size [even if one considers the
standard deviations) dropped since 2004, quite contrary to what was seen for the
equity funds. There appears to have been a redistribution of assets into equity
funds due to high stock market returns and also due to lower interest returns on
debt instruments.
5.3.2. Empirical Framework
A priori. theoretically the total cost is expected to be dependant upon the size of the
fund, the size of the fund family, the entry and exit load and the turnover of the
funds portfolio. Cost components such as management fees, and other expenses
including brokerage charges, research and marketing expenses are predominantly
influenced by asset size. But other characteristics such as total load (entry load and
exit load) charged by funds total family average assets and also the turnover of the
fund are also important. Entry load serves to defray marketing expenses for new
subscribers and exit load attempts to discourage early redemptions which can
cause unwanted portfolio churning. Hence, total load should have a negative
influence on costs. Family size can help reduce average fixed costs per fund and
also reduce the average research expenses for a fund as it is common
knowledge/expense whose cost is assumed to be shared between all the funds of a
family. Turnover of the portfolio has a positive impact on costs as larger the
churning of the portfolio larger the absolute amount of brokerage fees to be paid.
These variables are described in table 5.3.
93
Table S.3 - Cost function and explanatory variables
Cost..
trotal
Includes the sum of managerial fees. marketing
pperating
expenses and other expenses such as brokerage,
p>sts
shareholder transactions, registrar fees, etc of the ith
fund in year.
LAAn
,...og of
Average of weekly assets under management of the
I"Iverage
i
lh
fund in year.
!assets
LAASQ.
,...og of
Average of weekly assets under management of the
fiverage
i
lh
fund in to. year.
!assets

LTAA.
r-og of
It is the sum of the average weekly assets of all the
amily
funds under management of the fund complex to
!assets
which the fund belongs to in the to. year.
TloIIdtt
trotalload
Sum of the entry and exij loads of the i"
fund in to.
year. It is expressed as percentage of investment
made and/or redemption.
T
frumover
The minimum of sales or purchases as a percent of
average weekly assets
By accounting for all these factors the genuine relationship between
operating costs and asset size of a fund is sought to be derived. To further check
for the relevance of the explanatory variables a simple correlation is presented in
table 5.4.
We notice that all the theoretically assumed important variables have a
II8tiStiC8HY significant relation with the dependant variable Leost. However, the
coeffjcients of turnover and \load have unexpected signs. One reason for this could
be that funds which have experienced higher marketing expenses and redemptions
tInd to have shifted to larger loads and hence the positive correlation. Higher
UrIO'I8I' leading to lower costs could be due to the fact that larger fundS selected
94
are predominantly large cap-growth stock oriented and such funds normally evade
from too much of churning of the portfolio as it has adverse impact on returns. As
expected log average assets (Iaa) and log of family average assets (ltaa) have a
reasonably strong positive correlation (O.41).Total load has a small positive
correlations the strongest being with family assets. Turnover has small negative
correlations with average assets and a small positive correlation with family asset
size. It helps to control for these factors before examining the relation between cost
and asset size.
Table 5.4: Time series, cross section averages of (yeariy) conelations
between variables of interest for equity funds
Lc:ost
AA La
Laaaq
1.00
0.99 0.99 0.94
Leost
(-10.33) (-508.21) (-31.8)
AA
1.00 0.71 0.84
(10.2) (9.7)
1.00 0.96
LAA-
(-26.9)
LAASQ***
1.00
LTAA-
TLOAD"
Turnover
AA represents (lIIerage assel sc:e oflhe mdlVlduolfund.
LAA is the nalural log of assels .
LAASQ is LAA squared
@ LTAA is Ihe log offamily assel si=e.
Ltao
0.39
(-83.85)
0.40
(-20.16)
0.41
(-0.42)
0.48
(20.16)
1.00
@@ TLOAD is Ihe 10101 load which is the sum of enlry and exilload.
Figures in parentheses are I-values.
All compulaJians by lire aulhors.
Tload Turnover
0.07
-0.09
(-12.91)
(-12.59)
0.07
-0.13
(10.26)
(1.08)
0.08
-0.08
(23.1)
(-12.4)
0.05
-0.12
(29.96)
(-11.32)
0.04
0.14
(74.48)
(-12.22)
1.00
0.01
(12.53)
1.00
95
In the case of debt funds the family size and average assets are weakly
negatively correlated. Turnover, however, has a reasonably strong posnive
correlation wnh family size and a negative correlation with asset size. larger funds
tend to have less churning but larger families increase the same. In the case of
larger families this could probably be due to larger inter-fund transactions. Total
load while having a small positive correlation wnh asset Size has a reasonable
negative correlation with family size. Hence in the case of debt funds as well all the
above mentioned variables are retained.
Table 5.5: Time series, cross section averages of (yearly) correlations
between va riables of interest for debt funds
Least AA
Lao LMoq Llaa noad Turnover
Lcost 1.00
AA 0.79 1.00
(-9.19)
LAA 0.99 0.81 1.00
(-242.59) (9.13)
LAASQ 0.98 0.87 0.99 1.00
(-30.64) (8.8) (-26.9)
LTAA -0.07 0.Q1 -0.07 -0.06 1.00
(-52.2) (9.06) (-22.52) (21.5)
T 0.1 -0.21 -0.14 -0.16 0.23 1.00
(10.35) (-2.09) (-11.45) (-11 ) (-11.4)
TLOAD -0.19 0.02 0.03 0.04 -0.18 -0.33 1.00
(-11.5) (9.2) (49.67) (28.93) (85.79) (11.53)
Once again all the theoretical explanatory variables have a statistically
significant correlation with the dependent variable lcost and all the correlations are
of the expected sign. Importantly the correlations with the dependent variable are
larger than or equal to the correlations between the explanatory variables. This is
96
useful as it reduces the role of multicollinearity. Although this was not so the case
for equity funds given the significance of these explanatory variables log of the
variables is used to reduce multicollinearity and the variables are retained.
The functional form of the model is therefore given as below:
C = C{AA,TAA,TLOAD ,T}
(5.1)
The empirical methodology consists of using a fixed effects approach to
detenn ine the impact of fund size on fund operating cost. Funds are divided into
two broad categories - equity and debt. They are taken separately give their
different cost regulations and investment portfolios. In order to reduce the
multicollinearity problem and to identity presence of economies of scale with
varying asset size a log-log model is used.
L cost
it
= a
l
+ a
2
1aa
it
+ a
3
(laa;Y + L j aJx
jit
+ e (5.2)
i= 1 ..... N
Lcost" is the natural log of operating costs of the ith fund in the year t.
Laa., is the natural log of the average assets of the ith fund in the year t.
(Lao)' is the square of the log of average assets to capture economies of
scale.
X. is the vector of fund characteristics that can affect costs. It includes family
J
asset size (LT AA). total load (TLOAD). turnover (T). and regulatory cost ceiling
(RCOST) as a control variable.
For both the equity and debt funds the regressions are carried out in two
stages. First. without the control variable and then. with the control variable. This
helps us to understand the impact of regulatory cost ceilings.
97
5.4. Results and analysis
Guided by the Hausman specifICation test provided in table 5.6 a fixed
effects model is used for the unbalanced panel data on equity funds. At first the
regression is carried out wnhout the control variable of regulatory costs. The resuhs
of the same are presented in table 5.7. The results are as expected with the
coefficient of laa having a posnive sign and the coeffICient of laasq having a
negative sign. None of the other variables have any explanatory power. This
indicates that there are economies of scale present and that total costs are
increasing at a decreaSing rate. This, however, as pointed out could be merely due
to forced economies created by regulations. In order to verify this, the regression is
run again with the control variable of regulatory costs. These results are presented
in table 5.8.
The results show that the coefficient of Laasq is no longer signifICant and
has a posnive sign. The control variable has the expected negative sign and has
absorbed all the possible economies of scale. Hence, regression results with
regulatory cost ceilings used as control variables reveal no true economies of scale.
All economies are strictly due to the extent caused by regulations. Mutual funds
either have no scope for further reduction in costs or even if there is a possibility
they do not show any inclination to do so. Total load is statistically inSignifICant and
turnover of portfolio has no signifICant impact on cost. Importantly the resuhs show
that overall size of the fund complex does not contribute to reductions in fund
expenses. SEBI regulations require that non-fund specifiC expenses be distributed
across all funds in the family in proportion to the asset size. These could include
98
research expenses. These expenses have no impact on cost as the family
expands.
Table 5.6: Correlated Random Effects - Hausman Test
Tn'Summary
Cross-section
random
Chi-Sq. Statistic Chi-Sq. d.f.
30.966754 6
Prob.
0.0000
Table 5.7: Regression results without the control variable for equity funds.
Variable Coefficient Std. Error t-Statistic Prob.
C -3.809811 0.061342 -62.10753 0.0000
lAA 1.027017 0.012975 79.15149 0.0000
lAASQ -0.005694 0.001466 -3.885183 0.0001
LTM 0.004396 0.007591 0.579037 0.5632
TURN 6 . 1 1 E ~ 5 2.46E-05 2.480224 0.0140
TLOAD -0.008418 0.007957 -1.057905 0.2914
R-squamd-O.99
Table 5.8: Regression results with control variable for equity funds.
Variable Coefficient Std. Error t-Statistic Prob.
C
-3.802441 0.060688 -62.65582 0.0000
lAA
1.013185 0.014033 72.19810 0.0000
lAASQ
-0.001639 0.002213 -0.740595 0.4598
LTM
0.002288 0.007551 0.303054 0.7622
TURN
5.98E-05 2.44E-05 2.456575 0.0149
TLOAD
-0.008071 0.007864 -1.026405 0.3059
R squamd = 0.99
In the case of debt funds again a fixed effects model is applied justified by
the Hausman specifICation test in table 5.9. Once again the analysiS is done with
99
and without the control variable. Table 5.10 gives the results without the regulatory
cost control variable. As expected, the coeffICient of laa has a positive sign and the
coefficient of laasq has a negative sign. Both are highly significant. This implies that
debt funds experience economies of scale. But, interestingly, family size seems to
have a positive impact on the cost of operation of individual funds. This implies that
family size somehow induces diseconomies for debt funds but no similar relation
was seen for equity funds. The economies of scale seen could again be due to the
forced hand of regulatory cost ceilings. So the process is repeated with the control
variable. The resuHs are given in table 5.11 .
Table 5.11 shows that the coefficient of laasq retains the negative sign and
continues to be significant at the five percent level. What is interesting is that the
regulatory cost ceiling is not a significant determinant of the overall economies of
scale. Hence, debt funds tend to reveal true economies of scale or economies
beyond what is stipulated by regulations. Family asset size continues to have a
small impact on the cost of individual debt funds. Total load and turnover do not
seem to be important factors in explaining the cost trends. Other factors, such as
retums, seem more important in determining costs.
The positive impact of family size on debt fund cost is a bit of a puzzle given
SEBl's requirement that common costs be distributed on a proportional basis
across all funds in the fund family. The possibility of larger families tending to be
more immune to cost considerations has less bearing for debt funds which faced a
run on their assets given superior equity returns and also decreasing interest rates
in India.
100
Table 5.9 : Correlated Random Effects - Hausman Test
Test Summary
Cross-section
random
Chl-Sq. Statistic
17.108111
Chi-Sq. d.f. Prob.
6 0.0089
Table 5.10: Regression results without the control variable for debt funds
Variable Coefficient Std. Error t-Stati.tlc Prob.
C
-4.700793 0.169473 -27.73766 0.0000
lAA
1.186152 0.049506 23.95966 0.0000
lAASQ -0.019211 0.004410 -4.356013 0.0000
LTAA
0.022510 0.009575 2.350827 0.0204
TURN
4.67E-06 1.58E-05 0.295249 0.7683
TLOAD
0.000161 0.064823 0.002485 0.9980
R squared - 0.99
Table 5.11: Regression results with the control variable for debt funds
Variable Coefficient Std. Error t-Stati.tic Prob.
e
-4.825338 0.224297 -21.51317 0.0000
lAA
1.246100 0.086270 14.44423 0.0000
lAASQ -0.026089 0.009226 -2.827720 0.0055
LTAA
0.021454 0.009667 2.219334 0.0284
TURN
5.45E-06 1.59E-05 0.343743 0.7317
TLOAD
0.006915 0.065386 0.105759 0.9160
RCOST
0.002230 0.002626 0.849002 0.3976
R - squBf9d 0.99
101
These results make it clear that regulatory ceilings have contained costs for
equity funds but have no similar impact for debt funds. In order to understand the
sources of such constraints (or the lack of it), for equity (debt funds) a
disaggregated look at the composition is attempted. The following section attempts
to do the same and also examine fund behaviour with respect to management fees
and marketing expenses.
Expenses can be split into management fees, marketing expenses and
other expenses. The decomposition is done so deliberately in order to have a
glimpse of management fee as a price variable and marketing expenses as a non-
price instrument of competition. These two variables are much within the control of
funds and can be decreased or increased depending on competition levels. Other
expenses include costs of investor communication, mandatory fees, and auditing,
trustee, brokerage, and other transaction costs. These are the expenses which we
would expect to see economies or diseconomies if any.
Table 5.12 gives the disaggregated cost structure of equity funds. Small
funds with assets less than 1 billion rupees tend to charge expense ratios, which
are much below the ceilings on an average. While this is the case for the next two
higher asset classes to a smaller extent, the gap disappears for the largest asset
class. Even though expense ratios show a falling trend, they tend to collide with the
ceiling which is the reason why there were no economies of scale after controlling
for regulatory ceilings.
102
Table 5.12: Time series cross section averages of expense components of equity
funds
variables <-1
AA-
0.43
(0.28)
AER-
2.29
(0.31)
RER'
2.5
(0.00)
AMFEE$$
1.10
(0.26)
RMFEeO
1.25
(0.00)
ME ....
0.59
(0.57)
RETURNS 52.31
(53.76)
OE
0.60
Average assets In rupees billiOns
.. Average of actual expense ratios
1 -4 4-7
2.22 5.07
(0.94) (0.84)
2.32 2.20
(0.16) (0.22)
2.39 2.27
(1.11) (0.05)
1.09 1.01
(0.15) (0.21)
1.13 1.06
(0.06) (0.02)
0.68 0.77
(0.30) (0.20)
52.32 50.52
(52.57) (57.26)
0.50 0.42
."Average of the 10101 operating expenses minus the sum of manage menifee
and marketing expenses.
$ Regulatory expense ratio ceilings
$$ Actual management fee charged
@ Regulatory ceilingfor management fee (as a percent of assets)
@@ Marketing expenses as a percent of average assets.
>7
13.7
(6.56)
2.04
(0.13)
2.00
(0.22)
1.02
(0.08)
1.02
(0.01)
0.54
(0.23)
41.97
(41.67)
0.46
On examining the management fees we notice a distinct tendency among
the smaller funds to waive off a portion of the allowed management fees. The gap
between the allowed and the actual management fee tends to close until they are
the same for the largest asset size. The largest fund class charges the maximum
permissible. Most, but not all of the below-the-ceiling expenses can be explained by
the lower management fee. Hence, it can be argued that smaller funds try to be
more cost competitive by cutting down on management fees chargeable.
103
Marketing expenses as a percent of assets tends to increase as the asset

size increases until it dips for the largest asset category. Marketing expenses are
not a transparent category and one can only assume that it is used to cover
advertisement expenses or brokerage expenses. It is akin to the 12b-l expenses of
the US mutual funds. Such expenses are supposed to attract more investments,
increase the size of the fund and thereby lead to cost savings. But new investors
also pay an entry load to defray such expenses. Besides, the marketing expenses
appear to be negatively correlated with annual average returns. Funds seem to be
spending more on brokerage and advertisements to cover for relative
underperformance. Given these observations it is a surprise that marketing
expenses remain so opaque and unexplained for so long. The fact that the trend in
the gap between allowed and actual management fee and the doubtable marketing
expenses it appears that funds cost consciousness decreases with size.
Other expenses, where economies were expected, predictably dip but
increases again at the last asset class. The dip in marketing expenses for the
largest class appears to be due to the regulatory constraint along with
diseconomies creeping in. Given that diseconomies creep in for the largest asset
class the justification for marketing expenses becomes weaker as it would be
difficult to meet regulatory ceilings unless they cut management fees.
Regulatory ceilings seem to be most effective as a cap for the largest asset
class witnessing diseconomies and exhausting behaviour in terms of management
fees charged and marketing expenses incurred. But perhaps the ceilings can be
lower for all the asset classes given the questionable nature of marketing expenses
and their use.
104
For debt funds the actual expense ratio is always lower than the maximum
though the gap reduces with size. Managerial fees are waived off at all asset levels
with the tendency again reducing with size. Again they appear to be the most
important factor for keeping expenses below the ceiling. Marketing expenses show
an increasing trend and appear to be justified by the drop in average 'other
expenses' though not so much in actual expense ratios which ultimately matters.
Once again smaller funds show the willingness to cut costs through waiving
management fees and spending less on marketing. This appears to be guided by
the need to provide competitive returns. On an average, smaller funds have
actually given lower returns and this we feel could explain their attempt to cut costs
and give acceptable net returns. But the other expenses' dropping sharply is a sign
that substantial economies are present even in the largest asset category. This
proves the earlier regression results showing true economies for debt funds. The
source of this is not just due to containing management fees but also due to sharp
drop in other expenses which strengthen the argument that true economies prevail.
Table 5.13: TIme series cross section averages of expense components of debt
funds.
Variables
<1 1-4 4-7 >7
AA 0.59 2.37 5.29 15.56
(0.23) (0.82) (0.88) (8.63)
AER 1.68 1.76 1.59 1.67
(0.42) (0.35) (0.32) (0.12)
RER
2.25 2.02 1.64 1.72
(0.00) (0.31) (0.38) (0.1)
AMFEE 0.88 1 0.88 0.94
(0.32) (0.19) (0.20) (0.20)
RMFEE 1.25 1.12 1.05 1.02
(0.00) (0.05) (0.01) (0.01 )
ME
0.42 0.47 0.47 0.57
(0.25) (0.27) (0.27) (0.17)
R 7.32 9.11 10.99 10.15
(8.26) (7.07) (5.9) (5.37)
OE 0.38 0.29 0.24 0.06
105
5.5. Chapter Summary
This chapter has set out to examine if regulatory ceilings are too high or too low.
The WOrd "too" is used as one cannot expect a perfect ceiling but at least one which
would approximate the actual in a competitive market.
Equity funds show no 1rue economies'. Family size does not cause
expenses to decline either. Smaller funds tend to behave competitively by waiving
fees and keeping expenses below regulatory ceilings. But, as asset size increases,
they tend to exhaust most of the allowed expenses. Increase in marketing
expenses appears to be a prime reason for the tendency to close the gap with the
expense cap. The use of marketing expenses with entry loads and the tendency to
increase the former to possibly cover for poorer comparative performance is an
issue for concern. Large funds also seem to be experiencing diseconomies with an
upturn in 'other expenses' (OEl. Coupling this with lower returns, one is forced to
think if a size cap might be needed. Regulations prove to be a relevant constraint
for contrOlling costs in the case of larger funds particularly as it helps to curb
marketing expenses to accommodate increasing OE within an overall expense cap.
Debt funds maintain expense ratios persistently below the ceiling and also
show the presence of true economies. The lower expenses are aided by waiving a
portion of management fees and also through persistently decreasing OE. The
latter is most important for examining economies of scale and upholds the findings
of true economies in debt funds. Their main reason for keeping fees lower could be
the trend of decreasing returns on debt and good returns in the equity market. This
could lead to a refocus of fund manager's interest in debt funds as equity fund
106
management becomes more attractive in terms of fees. Interestingly family size
seems to have a p o s ~ i v e impact on debt fund costs.
107
CHAPTER-VI
FUND SIZE AND FUND RETURNS
CHAPTER- VI
Fund Size and Fund Returns
6.1 Introduction
The mutual fund industry in India has witnessed a sharp growth in recent
times. The growth was almost 50% during the financial year April 2006 to March
2007. The industry size as on October 2007 was close to rupees 5300 billion.
Households now save more than 5% of the savings in mutual funds as compared to
0.4% in 2002-03(Reserve Bank of India). Given their importance as instruments of
saving and their explosive growth recently we feel it would be important to examine
the impact of size of individual funds and fund families on the performance of funds.
The importance of such a study becomes all the more apparent considering the
voluntary caps imposed on the asset size of individual funds".
Negative influences on returns take place as open ended funds faced w ~ h
increased inflow may have a problem in terms of both timing and stock selection.
Larger funds may also find ~ difficult to be as fleet footed as smaller funds as their
transactions in the market are bound to be larger attracting adverse price
movements. Persistence of fund performance depends on the ability of funds to
continue to display superior micro and macro skills. This gets harder as successful
funds attract more fund inflows thereby increasing fund size.
32 For instance Reliance Equityfund decided to cap the amount o/money it raised through an IPO in
2006 (Rs.58 billion made iI the largest fund) because iI was worried about the difficulty of
generating good returns with a very large asset si:e. Few olher funds followed pursuit capping
their asset s;;e at much lower levels.
108
While this is a cause for concem to the investors in funds. fund managers
have every incentive to allow for increased asset size as their fees are a fIXed
percentage of the assets. But to do so despite the possibility of declining or lower
marginal return constitutes an agency problem detrimental to the investors. It has
been pointed out that larger funds generate econom ies of scale and therefore
reduCed operating expenses. This could be a valid factor if the retums net of
expenses turn out to be higher for larger funds. In the case of this in itself will cause
average expense ratios to drop. It would be of interest. therefore. to examine if the
net returns justify investment in larger funds.
The objective of this chapter is to understand the implications of size of AUM and its
impact on performance of open end equity diversified funds.
This chapter is divided into four parts. The second part deals with the empirical
frame work which discusses the data and the empirical model. The third part
discusses the resuijs and the last covers the summary and conclusions.
6.2 Empirical framework and data
6.2.1 Data
The lime period considered for the study is August 2002 up to October
2007. This gives altogether 63 months of data. Data on fund net asset value have
been sourced from the Association of Mutual Funds of India (AMFI)33. The sample
of funds includes 58 open end equity diversified growth funds selected purely on
lJ Expenses again h(]lle been capped by SEBI at 2.5 percent of the assets for the first one billion
rupees. 2.25 percent for the next 3 billion. 2 percent for the next 3 billion and I. 75 percent for the
rest. AMFI;s a vo/unJary association o/mutua/funds in India which seeks to act as a selfregulalory
body.
109
the basis of availability of data on monthly asset size from August 2002. The
sample data has been sourced from Mutual Fund Insight, a monthly published by
Value Research Inc".
Since fund retums are due to variations in style such as Large Cap, Mid
Cap, Small Cap and Growth stocks, value stocks or blend stocks orientation an
effort has been made to track changes in the style of funds over the period. Data
on fund style has again been sourced from Mutual Fund Insight.
The style of a fund can be described with the help of the following matrix
used by Value Research Inc.
Table 6.1 Fund style description
Growth Blend Value
Large Cap A B C
Mid cap 0 E F
Small cap G H I
A fund in the cell A is a fund that invests in Large Cap stocks and stocks
which have a high growth potential as reflected by a high Price/Earnings ratio (PE).
A fund in cell B invests in large cap stocks but has a mix of growth and value stocks
(stocks of companies which have a high book value but low PE and give good
dividends as well). A fund in cell C reflects a fund which invests in Large Cap value
stocks. Similarly we have Mid Cap and small cap oriented funds that invest in
growth, blend or value stocks. While some funds are fixed in terms of their style,
J< Value Research Inc. is an independent research company devoted towards the study of mutua!
funds.
110
some others are f1exi cap and move between large to small cap stocks. To track
such changes we use monthly data on style.
Data on expense ratio (percent of recurring expenses to asset size) is
sourced from the annual reports of various fund families. Since age generates
experience and knowledge of the market it is also included and all that was needed
was the inception data of the fund which was available in Mutual Fund Insight.
Data on the benchmark S&PCNX500 was sourced from the National Stock
Exchange (NSE) website. The CNX500 is a broad based stock market index
representing 96% of the total turnover ofthe NSE.
The risk free rate used is the three month implicit yield of the 91 day
Treasury bill given in the RBI monthly bulletin. Family asset size per month is
derived from AMFI. Total load is the sum of the entry load and exit load and data is
from Mutual Fund Insight. Flow represents the net inflow of open funds [sales over
redemption].
Table 6.2 TIme Series cross sectional averages and standard-deviaUons
Mutual fund size On rUI!!:" billion]
Upto 1 14 47 7 and more All fund.
Assets 0.39 2.21 5.38 15.2 4.08
(Rs.Billion) (0.27) (0.87) (0.86) (8.03) (6.32)
Family Asset 66.87 146.52 185.05 246.68 134.48
(Rs.Billion) (83.28) (99) (106.89) (121.17) (118.32)
Age 7.82 8.19 9.17 11.09 8.64
(Years) (3.04) (3.03) (254) (2.33) (3.11 )
Expense Ratio
0.175 0.19 0.178 0.163 0.178
(% per annum) (0.04) (0.028) (0.023) (0.02) (0.034)
Flow
0.404 6.8 10.11 26.05 7.76
(% per annum) (17.34) (69.22) (102.03) (228.2) (107.86)
TLoad
2.08 2.28 2.30 2.57 2.25
1%1
(0.96) (051) (0.37) (0.59) (0.75)
111
Table 6.2 gives the summary statistics of the sample. The means and
standard deviations (in parenthesis) of the variables of interest are mentioned. The
spread of the asset size is large and obvious as reflected in the standard
deviations. The average family size is larger, for larger funds. The same trend is
noticed with respect to age as well. Larger funds have been in existence for a
longer period of time. Their average age in years is 11.09 as compared to the
average of 8.64 for all funds. The expense ratio is the annual expense ratio divided
by 12 to give a monthly average. It shows a declining trend with the smallest asset
class bucking the trend and actually having an expense ratio higher only compared
to the 4 billion class.
Average flow and total load are found to increase with fund size. The
largest fund size has the highest average load. This could actually be because
larger funds face market impact problems while dealing with large scale
redemptions.
Table 6.3 - Time series averages of the cross sectional correlations
between the various fund characteristics
log log Age Total Flow
Asset Family load
Asset
Log Asset
0.64 0.32 0.28 0.07
Log Family
1 0.07 0.10 0.02
Asset
Age
1 0.28 0.01
Total Load
1 0.003
Flow
1
Table 6.3 on examining the cross sectional correlations between the fund
characteristics, we find that log asset has a reasonably strong positive correlation
112
with log family size. age and total load. It therefore becomes obvious that these
fund characteristics have to be controlled for before estimating cross sectional
relationship between asset size and retums.
The sample has been chosen keeping in mind the survivorship bias. Funds
which were terminated or merged mid-way through the sample were also included
which gave the data an unbalanced panel structure but addressed the survivorship
bias problem. Otherwise the correlations between age and fund size could
have been stronger.
Table 6.4 - Means and standard deviations for the monthly fund retums
Mutual fund asset Bize [in rUe"! billign]
<1
1-4 4-7 7>
Net Fund
3.03% 3.57% 3.86%
4.25%
Returns
(7.38%) (6.88%) (6.84%)
(6.17%)
Gross
3.24% 3.76% 4.04% 4.41%
Fund
Returns
(7.42%) (6.88%) (6.84%) (6.17%)
Table 6.4 reveals that mean returns show an increasing trend with asset
size. This is so for both net and gross fund returns. On the face of it. without
controlling for other fund characteristics there seems to be no decreasing returns to
scale. But simple fund returns alone may not reflect the relation between size and
returns. It is important to have an idea of the ability of the fund to outperform the
market on a risk adjusted basis or absolute basis controlling for other fund
characteristics including style. The ability to do so should get tougher with size.
113
6.2.2 Empirical framework and model
Fund returns were computed by using the following formula:
(6.1)
NA V. - end ofthe month net asset value (NAV)
NAV._. - beginning of the month
Similarly monthly returns are computed for the benchmark index - CNX500.
Funds are divided into the asset classes 0-1 billion. 1-4 billion, 4-7 billion
and 7 billion as this is the division created by the regulator SEBI, for purposes of
benchmarking expenses. Individual regressions are run for each of the four asset
categories using the following specifications to derive the Beta or the market
benchmark correlation (systemic risk). A single factor CAPM is used to derive the
beta
3S

(6.2)
R n;p is the return of the fund i in asset class n.
R,the Risk free return (or 91day t bill return) sourced from the RBI
Pn is the systemic risk for the specifIC asset category considered.
n represents the four asset classes (up to Rs. 1 billion, 1-3 billion, 3-7 billion and
above seven 7 billion)
Next Gross Beta adjusted returns and Gross market adjusted returns are
computed as follows:
JS We continue with the single factor model as we later segregate funds on the basis of the fund
portfolio or style. This should allow us to differentiate performance of funds which could be different
depending on whether they are value stock Igrowth focused and small capllarge capitalized stock
orientation.
114
Beta adjusted returns = Returns. _ j3" (CNX500 returns). (6.3)
This helps us to arrive at the risk adjusted excess returns of the fund as
compared to the index, CNX500. Market adjusted return is essentially the
difference between the fund return and the index return. This aims to check for the
influence of size on the ability of the fund to outperfonn the market without any
adjustment for risk. The ability to outperfonn the market should be much more
diffICult as size increases.
The influence of various factors including size on these adjusted returns can
be represented in the following functional fonn.
adjrelurn (R a) = R(assel ,jamilyasse I, flow, age ,lolaUoad ,fundstyle ) (6.4)
On deriving these two adjusted returns the regression specified by equation
6.2.2.4 is used for both these returns separately.
Retums.=c+ 0, In (asset . ,) + 02 In (Family Asset..,) + 03 Flow . , + 14 age .. , + 05
(6.5)
i'" 1, .. , N funds
t=1, .. , rn months
Monthly Flow is computed as follows:
'1 _ [A A ] I Re I ~ s s e Is,.! j
F,ow I - ssets I - ssets I-I - t 100
(6.6)
Where t-1 is the beginning of the month and t is the end of the month. The
In1pact of fund size and family size on fund returns, both gross (inclusive of
expenses) and net is sought to be derived by controlling for fund specific qualitative
115
factors such as age, flow, total load and style. Style here is represented by two
dummies 0, and O
2
.
1 if growth stocks oriented
0,=
o if blend or value stock oriented
1 if large cap
O
2
=
o if mid or small cap oriented
6.3 RESULTS
Table 6.5 - Mutual fund Beta's and constants across different asset classes
with CNX500 as the benchmark index.
A.set class [in ruoees billion]
<1
14 4-7 7>
Constant 0.74 1.06 0.85 0.82
(0.00) (0.00) (0.00) (0.00)
P
0.73 0.71 0.84 0.77
(0.00) (0.00) (0.00) (0.00)
R' 0.54 0.54 0.70 0.63
Figures in parenthesis represent the p-values
Table 6.5 shows the results of the regression using equation 6.3.2. The
Beta's are persistently below one for all funds reflecting a risk level lower than that
of the index. Most funds keep very little cash and stay invested in stocks hence the
lower beta cannot be attributed due to investment in short term debt. The constant
is the highest for the middle two asset classes reflecting superior stock Picking
capacity. Hence the average betas being less than one cannot be explained by
cash or debt holding.
Using these beta's beta adjusted returns are derived (Table 6.7) and the
regression (Table 6.8) is carried out. A random effects model is used for beta
116
adjusted retu
rns and a fIXed effects model is used for the marKet adjusted returns,
the choice be'
In9 based on the Hausman specifICation results. The Hausman
specifi .
lCalion results are provided in table 6.6 below.
Table 6.6 - Correlated Random Effects - Hausman tast
Test summary
Cross sectlon
random effects for
beta adjusted
returns
Cross sectlon
random effects for
market adjusted
returns
Chi-sq
statistic
7.71
12.14
Chl-sq d.f Prob
7 0.34
7 0.09
Table 6.7 - Regression of Beta and market adjusted fund performance on fund size
and other characteristics over one period lagged effects
Beta adjusted Marl<et adjusted
returns returns
Intercept
0.68 (0.40) 2.95 (0.02)
Log Fund Size
0.26 (0.01) -0.18 (0.25)
Lag Family I Fund -0.11 (0.26) -0.22 (0.25)
Size
Age
-0.06 (0.15) 0.01 (0.90)
Total load
-0.24 (0.13) -0.02 (0.91)
Flow
0.00 (0.37) 0.00 (0.00)
0, (Growth Stock)
-0.15 (0.59) -0.02 (0.91)
O
2
(Large cap)
-0.42 (0.09) -0.48 (0.02)
Figures In parentheSIS represent the p-values
In Table III (3) for beta adjusted returns fund size has a p o s ~ i v e impact on
retums and large cap funds have underperfonned medium and small cap funds in
tennS of risk adjusted excess perfonnance. None of the other variable seems to
have an impact on beta adjusted returns. For marKet adjusted returns none of the
117
variables are significant except for the dummy D2 representing large cap funds.
Large cap funds have again underperformed in terms of excess absolute returns
over and above the index.3637
This indicates that larger funds actually deliver higher risk weighted excess
returns. This, however, could be because of the sample giving the average of bull
and bear phase performance in a sample time with larger nurnber of bull periods.
In order to further explore the performance of large funds over bearish and
bullish phases, of the market, the sample months are s p l ~ into two periods where
return of CNXSOO is either greater or less than zero. CNXSOO returns above zero
are considered as bullish markets and returns below zero are taken as bear
markets. Regression (6.3.4) is repeated again for Beta and market adjusted returns
for bullish and bearish market periods separately. The tables 6.3.4 and 6.3.S give
the results.
This decomposition shows that larger funds show negative correlation
between asset size and returns during bearish phases and vice versa during bullish
or positive returns phases of the CNXSOO.This resuH proves that larger funds fund it
difficuHy to pull out of or face larger impact costs in falling markets as their larger
transaction cause negative price impact.
36 However. it must be noted that the fixed effects approach is subject to a regression-to-the-mean
bias which can result in showing an inverse relation between performance and size. The random
effects approach when used gave a positive significant relation for market adjusted returns with size
and a significant negative relation with load and age. The rest of the variables were of the same sign
and did not differ substantially in significance or impact.
118
Table 6.B: Regression of market adjusted retums (In baar & bull phases of the market)
on lagged fund size and other fund characteristics.
Bear Phase Bull Ph.s.
(671 fund months) (2251 fund months)
Intercept
3.99 (0.01) 0.86 (0.38)
Log asset u-.
-0.42
(0.03) 0.29 (0.02)
Log Family ,,_.
0.33 (0.09) -0.2 (0.13)
Asset ','_'
Age ",.,
-0.15 (0.09) -0,02 (0.68)
Tolal load ,,_.
-0,74 (0.01) -0.23 (0.18)
Flowu_.
0.00 (0.00) 0.00 (0.00)
D.
-0.09 (0.83) 0.07 (0.8)
D,
0.58 (0.19) -0.69 (0.01 )
Figures in parenthesis represent the ~ v a l U 9 s
For beta adjusted returns based on the Hausman test a random effects
model and a fixed effects model are applied for bullish and bearish markets
respectively. The test results are not present for brevity, as ~ follows the same
pattem as for earlier regressions for the complete period.
Table 6.9 - Regression of bala adjusted returns (in baar & bull phases of the market)
I dfu d' d th f d h t' Ii on agge n size an 0 er un c arac ens es.
Bear Phase Bull Phase
(671 fund months) (2251 fund months)
Intercept 9.2 (0.00) -1.56 (0.32)
Log asset., .
-0.88 (0.01 ) 0.38 (0.01 )
Log Family,,_.
0.87 (0.04) -0.17 (0.22)
Asse!;.._.
Age"._.
-0.57 (0.01) -0.02 (0.70)
T olal load, .. ,
-1.17 (0.00) -0.09 (0.62)
Flowu_. 0.00
(0.96) 0.00 (0.00)
D.
0.06
(0.91) -0.31 (0.22)
D, -0.52 (0.41) -0.67 (0.03)
Figures In parenthesIs represflnt the ,rvalues
119
When the test is repeated for beta adjusted returns size. age and total load
show negative impact on retums. Older funds and funds with higher total loads do
worse during such phases. But interestingly funds in larger families seem to do
better. This could perhaps be due to larger fund houses spending more on research
and achieving superior stock selectivity. The variable of interest. fund size behaves
in a manner predicted and larger funds do worse in bearish markets. In bullish
markets larger funds do better as indicated by the positive and statistically
Significant coeffICient. None of the other variables are significant excepting for the
dummy D3 which shows that large cap stocks oriented funds do not do as well as
mid and small cap stock oriented ones
38
. This shows that better performance in the
bullish markets seems to help overcome underperformance in bearish markets for
the larger funds.
6.4. Chapter Summary
Most Indian mutual funds cannot be compared in terms of size to their
counterparts in the US or other developed markets. Yet there are seeds of
diseconomies that seem to be arising akin to that in the US funds. Though the
average performance of funds both beta adjusted and market adjusted do not
reveal diseconomies. Larger funds seem to under perform to a larger extent during
bearish phases of the market after performances are adjusted for fund
characteristics. Given more positive or bullish phase months it appears that larger
funds perform better only on an average. Further it appears that larger families
generate positive influences on adjusted fund returns during weaker market
38 Again it has to be pointed out that the fixed effects regression-to-the-mean-bias is a factor as in a
random effects situation the coefficient of log asset is significant at five per cent levels but is around-
0.48, a much lower negative relation. The positive impact of family size is also lower at 0.39.
120
periods. This aspect has not been dealt with in greater detail. But this could be due
to the ability of large fund houses to maintain in-house research teams which can
add value to retums generation.
Growth of individual fund size is, therefore, a cause for concern and justifies
the recent moves on the part of certain funds to curtail size. But should SEBI step in
to mandatorily reduce size? We again believe that the tendency of funds to
voluntarily curtail size shows that concern over generating competitive returns has
caused funds themselves to take suitable action. The role of SEBI could come in
when a fund desires to limit the size of its assets when it has grown over a period of
time due to inflow of funds and increase in stock prices.
121
CHAPTER - VII
SUlULARY OF FINDINGS AND POLICY
SUGGESTIONS
CHAPTER - VII
SUMMARY OF FINDINGS AND POLICY SUGGESTIONS
7.1. Summary
Mutual funds in India are emerging as an important instrument of household
savings. II has the potential to rival bank deposits for attracting household savings.
Given its present and potential importance a study of the performance of mutual
funds and the role of regulations in preventing investor-manager conflict of interests
becomes crucial. The few studies which have dealt with fund performance, in terms
of returns net of expenses, have not considered the role of regulations in
influencing fund behaviour. We started the study by examining some popular
measures used to convey risk weighted return. The Sharpe ratio and Treynor index
are among the widely reported in various mutual fund annual reports and mutual
fund specifIC journals such as Mutual Fund Insight. Since these measures do not
reflect the tnuer risk of returns below mean or minimum acceptable returns we felt n
would be important to arrive at a better measure and see if it affected the ranking of
funds. We then sought to examine if regulations have influenced performance.
Further since regulations also control operating expenses and management fee of
funds, the study focuses on the effectiveness and need for such controls. Lastly it
studies the increasing size if individual funds in terms of assets managed and the
possibilities for new areas of potential regulation.
In order to pursue this study the discussion through the thesis has been
divided into seven chapters.
122
Chapter One is an introductory chapter which underlines the evolution of
mutual funds in India. It also discusses the regulatory structure for this industry and
the importance of mutual funds.
Chapter two focuses on review of literature pertaining to the various
objectives of the study. There is a substantial amount of literature dealing with the
performance of mutual funds more specifically in the United States of America. The
literature has evolved from the focus on 'pure performance' to various factors that
influence the same. The need for considering alternate approaches to riSk,
importance of style and size in influencing performance and the relationship
between asset size and operating costs are discussed. The same is considered for
India and the gap in research is obvious. There exists practically no work which
tries to establish the net benefit of regulations and its effectiveness of the same in
controlling costs. Further, the issue of fund size and diseconomies in retums is also
very important but, not dealt with adequately. The review of literature therefore
points the evolving methodologies and issues and the lack of such studies in India.
After identifying these gaps the study has framed its objectives and analyzed the
same. The resuHs are summarized below:
7,1.1. Relative Fund Perfonnance Using Alternate Risk Weighted Returns:
Mean-Variance and Lower Partial Movement
In chapter three an attempt has been made to study fund performance using two
different approaches to risk and the consequences of the same for fund
performance ranking. The first measure of risk which is widely used is the standard
deviation of returns. This approach gives us the popular risk weighted measures,
Sharpe ratio and Treynor index. Since these measures are based on standard
deviation measure of risk they are susceptible to errors due to non-symmetric
123
distribution of retums. Hence we compute the Sortino ratio which uses the returns
below a certain minimal acceptable retum as a truer measure of risk. The results
are briefly summarized as follows.
The chapter first tries to rank funds according to their performance. It then
uses the Sharpe ratio and Treynor index which are all based on the M-Vapproach
to portfolio studies. We find that 58 percent of the funds considered are able to out
perform the broad based index. the CNX500. That leaves us with almost half the
number of funds under performing the index. This is not a good sign as 48 percent
of the funds are not shOWing the benefrts that merit a management fee and other
expenses.
Next the chapter goes on to compare ranking of funds based on the Sortino
ratio which uses semi-variance as a measure of risk and the 91 days treasury bill
retums as the minimal acceptable return. We compare rankings based on the three
,
measures using the Spearman rank correlation coefficient. We find no signifICant
difference between them and hence conclude that the present widely used ratios,
Sharpe ratio and Treynor index give proper information.
7.1.2. Regulatory Constraints and Fund Perfonnance- Comparing
Alternate Regulatory Regimes
Chapter four makes an effort to check if regulatory constraints, and its
accompanying costs, have undermined the benefits. Since it involves the impact of
regulations on net performance (net of all direct and indirect costs) we needed to
compare fund performance to a situation with weaker regulations. The c0-
existence of a weaker set of regulations, the UTI Act of 1963 which govemed UTI
funds, allowed as a comparative regulatory benchmark. Funds regulated by SEBI
124
were compared to those of UTI to derive an average differential in terms of return
and portfolio selectivity skills. Our assumption was that superior regulations would
lead to greater due diligence and portfolio selectivity and hence deliver better net
returns. Our findings are as follows.
By and large SEBI regulated funds have outperformed UTI funds in terms of
risk weighted returns for the period June 1996 to September 2000. Out of the three
UTI funds, two under perform the index and so also two private funds. This holds
true for performance measured in terms of the Sharpe and Modified Information
Ratio.
We then proceeded to check for the stock selectivity skills of UTI fund with
the SEBI regulated fund. One would expect that the UTI, with its vast experience
and knowledge of the Indian markets would exhibit superior stock selectivity. We
hypothesize that the benefits of this could be undermined by moral hazards in
portfolio selection. This hypothesis is based on the poor corporate govemance
structure and weak disclosure norms for certain UTI funds. Hence, we feel they
would display poorer Jensen alpha's compared to the SEBI regulated funds. Our
study goes on to find that this poor selectivity is indeed the case for UTI funds.
Their average 'alpha' is negative and not statistical signifICant. This compared to
the private SEBI regulated funds which have a signiflCBnt positive alpha of 0.45.
Since UTI has no management fee we add average industry management fees to
the private funds returns and get an even higher and statistically signifICant alpha of
0.53. This difference we admit could be due to fund manager skills as well as
regulatory effects. But given the vast experience of UTI fun rnanagers or
administration one cannot expect them to be inferior the new comer private funds.
125
We believe ~ is the moral hazards of poor information disclosure along with the
other weak regulations which induced poor portfolio and hence poor returns.
SEBI's regulations have been able to induce better portfolio selectivity through
frequent disclosures and better corporate governance structures. Along with the
cap on expenses and management fees SEBI regulations have ensured better net
performance.
Based on our findings we feel encouraged to recommend certain
improvements in regulations to provide better incentives to perform. Firstly, the
number of independent trustee members can be increased. It was increased from
half the number to two-thirds in 1997. We believe this can go the whole way and all
can be independent members.
Further it is felt that the present management fee is 'weak-form performance
fee'. The management fee is linked to asset size. Hence a fund manager would
earn more if the open end equity fund attracts more investments. This attraction, n
is presumed, would be via better relative performance. But ~ has not been clearly
established if performance is the most important factor in attracting investments. In
fact marketing expenses or brokerage paid could prove more important in
influencing potential investors. Hence we would recommend stronger-form of
performance fee. This could initially be a non-symmetric fee with a base level fixed
fee and a bonus fee for superior performance. The base fee can be lowered from
the present allowed fixed rates.
126
7.1.3. Cost- Management Fee Regulation and Economies of Scale
In chapter five we examine SEBI's cost and management fee regulations and the
economies of scale in India mutual funds. The study tried to assess the
effectiveness of SEBI's expense ratio cap in controlling fund expenses. It also
examined fund behaviour in terms of actual management fee charged. The sample
covered a varying number of equity and balanced funds under the 'actively
managed' fund category and debt funds, both over the period April 2000 to March
2007. The main findings of this can be summarized as follows:
In the case of equity funds and balanced (equity oriented) funds we find that
mutual funds tend to charge lower than ceiling management fees and expenses at
lower asset levels but as the grow in size this tendency disappears. As size
increases average of other expenses (which reflects economies of scale) tends to
drop but starts increasing again for the highest asset class of RS.1 billion and more.
Hence we see diseconomies creeping in for mutual funds. In terms of actual costs
charged these exists no economies of scale with size that are greater than that
assumed by regulations. However on closer examination it is found that larger
funds tend to charge the maximum expenses allowed not due to an increase in
other expenses but also due to the unclear category of marketing expenses.
In the case of debt funds we find economies if scale which are greater than
what is granted by the regulatory ceiling. There is a perpetual drop in the category
of 'other expenses'. This however appears to be reaching a limit at an average of
six basis point percent of the assets. Further debt funds charge lower managerial
fees and expense ratios across all asset classes compared to the regulatory
ceilings. This appears to be due to the need for generating better returns in a
127
macro economic environment that saw dropping interest rates and simultaneous
high returns on the equity mar1<ets. Hence competijion from equity funds seems to
have compelled them to keep costs low through sacrifICing managerial fees.
The other important finding is thai family size seems to have no impact in
reducing costs any particular fund in the equity and balanCed fund category.
Sharing of mar1<eting and selling infrastructure wages of personnel involved and
also sharing the benefits and costs of research should have generated some gains.
But there are no economies generated through family size. On the contrary we see
a positive impact of family asset size for debt funds. This is a puzzling
phenomenon which needs to be further studied as normally common costs of fund
Operation have to be shared proportionally as per SEBI regulations.
We also find that the total of entry and exit load and Ihe lum over of portfolio
are no significant explanations for cost for both categories of funds.
These results lead us to the conclusion that policy caps have restrained
fund expenses at the larger level and that policy needs to examine the need to
charge 'mar1<eting expenses'. This accounts for a significant proportion of the
expense ratio, close to 25 percent for equity and 35 percent for debt funds. This
seems to have no clarity and is essentially involves spending more to promote a
fund at the expense of existing share holders. It needs to be clear as to whether
this is in any way culling on other expenses which investors might have to bear.
Further we notice a good trend in that small equity and balanced funds tend
to compete by keeping expenses and fees lower than allowed. This is an indication
128
that the market in moving towards a more mature phase with competition appearing
robust.
7.1.4. Fund Size and Fund Returns
The sixth chapter addresses the new issue of growing size of mutual funds. The
study focuses on open end equity diversified funds over the period August 2002 to
October 2007. The summary of the result are as follows.
We find that there is no impact of size on both beta and market adjusted
returns. But on decomposing the period into bearish and bullish phases of the
market we find that larger funds tend to under perfonn, in tenns of market adjusted
returns, during the bear markets. The better perfonnance during the bullish phases
of the market seems to have helped deliver an overall better return. Once again the
fact that mutual funds are voluntarily seeking to curtail size indicates the concern
over size affecting relative perfonnance. This we feel, is again a consequence of
competitive pressures. So even large funds, while continuing to charge the
maximum possible expenses and fees allowed, do seem to be concerned over their
competitive perfonnance. But this is not a tendency among all large funds and it
appears to be the beginning of a trend. We feel our study has two possible
limitations. We discuss them below
7.2. Limitations ofthe Study
The study of regulatory impact on due diligence portfolio selection and
returns depends on the single factor model alpha. This could be questioned
on two grounds. The alpha difference could be due to fund style or due to
superior fund managers. We feel this is not a serious limitation as UTI fund
129
managers should on the basis of their experience be more skilled than the
new fund managers. Further the diversifICation of fund styles was a
phenomena more witnessed after 2000.
Our study of economies of scale is hampered by the lack of hedonic variable
such as number of investors in afund and the division of a fund asset into
retail and institutional investors.
The cost of fund management could be higher when the average asset per
investor is lower due to diseconomies. However such data is not available
to the desirable extent
7.3. Further Scope for Study
We feel that with increasing frequency of data the following studies would be
important
The relevance of fund perionnance for attracting new investors.
The relevance of expenses for the ordinary retail investor in choosing a
fund.
The role of marketing expenses in attracting fresh investor.
7.4. Policy Suggestions and Concluding Observations.
In the light of the above results, this study makes the following comments on
and suggestions for regulatory refonn.
Despite the widespread studies on the limitations of the Mean-Variance
approach to risk we find that measure based on this serve the purpose well.
130
There is no need for emphasizing on the downside risk measure, Sortino
ratio, as there is no significant change in rankings of equity diversified funds
in term of performance. Use of many terminologies could lead to the
possibility of confusing the average retail investor.
Regulations have been able to induce due diligence in portfolio selection.
This we believe has been the most important factor in explaining the
superior average returns of equity diversified funds. We feel encouraged to
,
therefore, recommend further strengthening of regulations which have
limited potential for imposing costs. The number of independent trustees
can be increased to 100 percent from the present two thirds. The POrtfolio
disclosure frequency can be increased to a monthly basis as we feel there
are substantial gains to be achieved through additional transparency.
SEBI could now consider the possibility of a stronger -form performance fee.
The present asset size based fee assumes that asset size growth depends
on relative performance. This is not a certainty. Hence we Would
recommend a non-symmetric performance fee with a lower base fee,
compared to the present permitted fees, and a bonus for outperforming the
relevant benchmark index.
SEBI needs to examine the marketing cost aspect of expenses. At present
there is no clarity on this and it seems to promote asset growth at the cost of
existing investors. This could further lower expenses across aU asset sizes.
SEBI also needs to look at the possibility of funds aiming to curtail their
asset size. It needs to see that such a process does not harm the interest of
131
the investor. No caps on asset size are required as funds are voluntarily
restricting size due to com petitive pressures.
132
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