‘Passive investments will be a game-changer in mutual funds industry’

Suresh Sadagopan

There have been a lot of changes with regards to mutual funds in the past 10 years. These changes have incrementally advanced the case of the investors. Some of the developments were – entry load ban, disclosure of commissions earned, only trail and no upfront commission, introduction of direct plans, fund re-categorisation, total expense ratio (TER) reduction, etc.

The direct plans have got a lot of column space over the last 2-3 years. This is thought to be a disruption. It may be in a small measure. But the real game changer is yet to come.

Let’s discuss the game changers of the mutual fund industry.

Direct Plans

These give a choice to the customer to bypass a distributor, if they want to invest directly. In direct plans, the cost saving will be about 40-50% on an average, as compared to regular commissionable plans.

For those who have the necessary knowledge, time & inclination – Direct plans are a good fit. But for most people, advice is needed. In the case of a Regular plan, the agent gets a commission and offers advice regarding investments. The customer needs not pay a fee directly for their services, as the distributor is compensated by their Principal through commissions.

In the above model, conflict of interests would exist as the distributor is an agent of the Principal & can suggest something that is most remunerative to them.

If someone is interested in a conflict-free advice, then a fee-only advisor is the only choice. Such advisor would suggest direct plans only, where there is a lot of cost savings. Of course, a fee would have to be paid separately. Hence, savings itself is not the centre piece of a direct plan which a fee-only advisor would suggest.

The major advantage is that in the direct fee-only model, the advisor would be independent & only represent the client. The advisor here is unbiased, verifiably conflict-free, truly client-centric & acts as a fiduciary. The advisor would also need to have necessary qualifications & also meet the higher standards set for Registered Investment Advisers (RIAs) by SEBI.

In this situation when advisory remuneration is separated from the product, the advisor needs to be able to offer high quality advisories and services. If lacking, the client can stop paying the fee to the advisor, anytime.

This will not happen in a product where commissions are embedded and the client cannot stop the remuneration even if the service is poor. In regular plans, the client will keep paying the higher costs, as long as their investments are there, whether they get good service or no service. The client with a fee-only advisor hence gains back control over what he pays for advice.

So, these are major changes and they are playing out right now.

Online platforms

There are multiple online platforms which have sprung up, which are offering regular & direct plans. These platforms are making the investment experience painless & delightful. These platforms are hence making a huge impression on the younger set which is net savvy; they are the biggest patrons of such platforms.

Online platforms also offer appropriate information and many times a curated list of schemes to invest in as well. Some of the platforms offer some level of advice based on Algorithms. These are popularly referred to as robo advice. This kind of advice would do for someone with simple needs.

Many of these platforms deal in Direct plans and charge a small amount as fees (or even no fees for the moment), making them a real low cost option for customers. There are some big players like Paytm, ET Money & Zerodha Coin who have started offering direct plans, on their platforms.

A lot of investment will happen through these platforms in future due to ease of use, low costs, required level of advice, excellent execution & reporting capabilities.

Passive investments

Passive investments are those which do not depend on the capabilities of a fund manager, to pick up investment candidates. These passive investments typically track an index. Hence, the investments have to be re-balanced from time to time to correctly mirror the chosen index. The fund manager skill is not required here.

There are Exchange Traded Funds (ETFs) & Index Funds. The former can be bought and sold like a stock on the exchange and the latter can be bought like MFs. Passive funds have become very popular in US and have a very significant asset base.

Passive funds have very low expense costs. As compared to an actively managed equity fund, the expenses in a passive fund can be lower by between 1-2% per annum. This means an active fund manager needs to generate such a level of alpha just to equal passive investments.

That is becoming difficult as now the MF schemes need to track Total Return Index (TRI) as opposed to Price Return Index (PRI) earlier.

Secondly, the markets are maturing and information flow is much more perfect now, narrowing the opportunities for a fund manager to have access and use information not yet discounted by the market.

Thirdly, the recategorisation of MFs as required by SEBI has made the categories more sharply defined removing opportunities to seek returns by investing in subcategories that are performing.

Fourthly, as mentioned earlier, the difference in expenses between active funds and passive funds is huge, which gives the passive funds a clear edge due to the cost differential they enjoy.

What lies ahead?

All the three factors/trends are going to shape the MF industry. But, passive funds along with online platforms are expected to bring in a sea-change in the near future. Fund managers will have to work much harder finding the opportunities to outperform the index.

The effect of this is that the expenses will have to come down across the board. The total expense ratios charged by active funds will become far more competitive than they are now. The industry itself is poised for a major expansion and hence the expense reduction should not impact the MF houses or the distributors much as the volumes will shoot up too.

Direct plans are seen as a disruptor today. The real disruptor would be passive funds. And that would happen much sooner than most people think. My guess is anywhere between 3-5 years. In time, we will all know. Interesting times lie ahead!