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The Mutual Fund Show: How ETFs Became The Largest Category In 2021

How ETFs replaced liquid funds as the largest mutual fund category.

<div class="paragraphs"><p>Stock market movements on an electronic display. (Photographer: Michael Nagle/Bloomberg)</p></div>
Stock market movements on an electronic display. (Photographer: Michael Nagle/Bloomberg)

Assets of exchange-traded funds surged to overtake liquid funds as the largest mutual fund category in 2021, benefiting from new launches, investor interest, and inflows from provident funds.

The category closed 2021 with assets worth Rs 3.84 lakh crore compared with Rs 3.61 lakh crore for liquid funds or debt funds lending to companies for up to 91 days.

Several mutual fund houses have launched passive ETFs to avoid ceding the market to passive funds in categories where it's difficult to beat the benchmark.

“Employees' Provident Fund Organisation contribution is like a systematic investment plan for the entire mutual fund industry," Piyush Gupta, director, fund research at Crisil Ltd., told BloombergQuint’s Niraj Shah on The Mutual Fund Show. "All the contributions that come from employees in provident funds, by default 5-15% of that corpus typically goes into equity, on a month-on-month basis. So that's a big factor driving growth of ETFs.”

According to a Crisil study, the average alpha, or outperformance over the benchmark, for actively managed large-cap funds has been declining consistently over the last three years. “Even the long-term performance of actively managed large-cap funds is lower than the benchmark.” It has led investors looking to invest in large caps to opt for ETFs for exposure to the segment, said Gupta.

Though popular earlier, liquid funds lost their appeal as returns dipped in line with low interest rates, making other money-market mutual fund categories more attractive for investors with higher risk appetite, according to Gupta.

Liquid fund assets are now treated on a par with other debt MF categories as mark-to-market. Earlier, amortisation-based valuation limited volatility. As a result, investors chose to switch to overnight funds or debt securities maturing the next day.

In 2021, floating-rate and passively managed debt funds in the form of target maturity funds also gained traction. These are debt schemes with a specified maturity date aligned with the expiry date of bonds in the portfolio. It basically matures on a particular date, much like a fixed deposit.

Since floating-rate debt funds have variable interest rates they act as a “hedge against interest rate movement”, said Gupta. On the other hand, target maturity funds are popular and gaining traction from the credit quality, taxation benefits (after three years) and safety of portfolio, he said.

Watch the full conversation here:

What was the key development or takeaway (in the mutual fund industry) which you would have penciled in the note as well?

Piyush Gupta: For the mutual fund industry, if you look at the last calendar year (January to December), this was a period when the industry witnessed the highest growth in terms of assets under management.

The asset gain was close to Rs 6.7 lakh crores. If you look at previous year highs, in 2017, it was around Rs 4.8 lakh crore, and in 2020, which was again a good year for the industry, the gains were about Rs 4.5 lakh crore.

If you look within the mutual fund segment or in different categories, the trends were different especially for the last two years.

While the inflows were similar – about Rs 1.81 lakh crore for the overall industry – the gains were largely driven by equity mutual funds in 2021, while in 2020 it was largely driven by debt mutual funds.

It was on the back of this significant decline in AUMs that we saw in March 2020, at the onset of Covid-19, but still the category managed to gain. Outflows regained and were a key driver for growth in 2020. But in 2021, it is largely driven by equity for the overall mutual fund industry.

For the last three or four years that we've been doing The Mutual Fund Show, there's been a lot of chatter about how Exchange Traded Funds and passive investing will come to India, but maybe with a bit of a lag, and ETFs have some time to go. And in 2021, ETFs became the largest category. Tell us about the key learnings out of this development and why do you think this happened?

Piyush Gupta: ETF is a category which is seeing a significant amount of inflows. If you were to look at the investor segment, a large portion of that money is coming in from the institutional investors, the largest being the Provident Funds, including the Employees’ Provident Fund Organisation (EPFO).

These Provident Funds have a mandate to invest at least or up to 15% of their total investment during the year into equity, and a lot of these Provident Funds have opted for ETFs as an avenue to participate in the equity market. So, that is one big factor. It's like a Systematic Investment Plan for the entire mutual fund industry. All the contributions that come from the employees in these Provident Funds, by default 5-15% of that corpus typically goes into equity on a month-on-month basis. So that's a big factor really driving the growth of ETFs in the recent period.

The second factor is the fact that the performance of actively managed large-cap funds have seen a decline. We did a study sometime back where we found that the average Alpha for actively managed large-cap funds have been declining consistently. This is not just in the recent period but over the last three years, we have seen that even the long-term performance of actively managed large-cap funds is lower than the benchmark. It has meant that a lot of investors, who want to participate in the large cap category, are essentially opting for ETFs to take exposure to the large cap segment.

I reckon that is because of the rules and regulations that SEBI has put in, with regards to stock selection for the large cap funds, and the fact that the cost structures of an ETF would be much better than an actively managed large cap fund?

Piyush Gupta: Firstly, the expense ratio is very different for ETFs compared to actively managed funds. Even the boundaries under which the large-cap funds have to be managed also creates some limitations. For instance, they need to invest at least 80% into those large-cap stocks, where again the universe is limited to those 100 stocks. So, the ability to pick a winner within that universe of 100 stocks also gets limited.

What I was particularly interested in was the finding that Liquid Funds have lost their sheen. A lot of viewers would, by virtue of having learned this over the years, steadfastly believe that instead of putting money into a short-term deposit, it’s better to put it in a Liquid Fund because that gives better returns than the bank return. Now that might well be true, but Liquid Funds have still lost their sheen. Why is this happening?

Piyush Gupta: Liquid Fund was a major category, and still is a big category today. A large part of the money would be dominated by institutional investors. Even though retail investors would be putting in some money, a large portion of the AUM is still dominated by institutional investors.

There are a few things that have happened with respect to the category, which has led to the flattish AUM that we have seen in the last two years.

One is that in the last two years, the interest rates have been at a lower level. If you look at 2020 and 2021, the short-term interest rates have been extremely low, which has meant that even the returns from the Liquid Fund category have seen a decline. If you were to look at the period prior to maybe 2020, i.e. 2019, the average return would turn out to be about 6% or so.

If we look at the last couple of years, the returns have averaged around 3-3.5%. So, that is one factor which has played out.

Secondly, there are structural changes which have happened. For instance, earlier Liquid Funds were allowed to amortise their returns from the underlying holdings, which meant that the volatility in the performance was limited.

Post 2020 through, in a phased manner, what has happened is the entire portfolio of Liquid Funds are now mark-to-market, which means that change in the interest rate has a bearing on the pricing of underlying securities. It also meant that the portfolio managers have reduced their maturity, compared to say 2019 or 2018 earlier period.

There is also the introduction of a seven-day Exit Load which has come in. It means that anyone who is exiting a Liquid Fund within seven days has to pay an Exit Load. At times, the returns may not be sufficient enough even to cover for that Exit Load.

Institutional investors, who are possibly parking money for a period of less than seven days, have started looking at an alternate option in the form of Overnight Funds, because the returns between Overnight Funds and Liquid Funds are not very different. So, if we were to do a cost-benefit analysis, I might as well put money in an Overnight Fund if my horizon is less than seven days compared to a Liquid Fund.

The decline in performance is also because there is a requirement for Liquid Funds to have at least 20% of their portfolio into cash and equivalent, which means short-term instruments like reverse repo or maybe T-bills (treasury bills) and so on and so forth. The return generation capabilities are further constrained, given the fact that they have to construct a portfolio in this manner.

So, these are some of the factors which have played out for Liquid Funds in terms of slight decline in traction in terms of the category that we see.

Your note says that Liquid Fund category assets are now treated at par with other debt mutual funds as mark-to-market rather than the amortisation rule. Can you briefly talk about it?

Piyush Gupta: What happened earlier was if a Liquid Fund is holding a 30-day security or 45-day security, the yield to maturity on that security is say 6%, then that 6% is amortised every day. So, it's an accrual of 6% till maturity that the fund would get. Irrespective of change in the interest rate, the price of the security will continue to accrue during this period of time, which means that the interest rate risk on Liquid Funds was even lower. While the short-term instrument anyway has a lower interest rate risk with this accrual, it is even lower.

Now in the recent period, the security is required to be mark-to-market. For instance, if the interest rate goes up from today to tomorrow, then the price of the underlying security will go down. The degree is anyway lower because it's a short-term instrument but still there is a mark-to-market component which has come in.

If you were to look at the average maturity of Liquid Funds, prior to this requirement the average maturity of Liquid Funds were 45-50 days. Now, in order to reduce the volatility, even the maturity of this category within the portfolio has come down significantly. So, the valuation has also played a role, both in terms of performance as well as the way the portfolios are being constructed.

So investors are choosing, at least in the short-term side, the Overnight Funds as a category as opposed to Liquid Funds.

Piyush Gupta: Yes, especially, for the period less than seven days.

Tell us about your findings that Floating Rate and Target Maturity Funds are gaining traction. What kind of investors are they suited for and why have they gained traction?

Piyush Gupta: Floating Rate Fund, the SEBI definition says, you need to invest atleast 65% of the portfolio into floating rate instruments. Now, floating rate instruments are different from conventional fixed income securities. In a conventional fixed income security what you have is a fixed coupon, and if the interest rate goes up, the price of the security goes down and vice versa.

Now, in case of a floating rate instrument, the coupon which is there gets reset on a reset date.

So, for instance, if the interest rates were to go up, then the coupon received or accrued also goes up during that period, which means that the floating rate instrument, in a way, becomes a hedge against interest rate movement.

In the last one year or six months or so, there has been expectation that the interest rates are likely to go up. In fact, in the last quarter, we have seen a rise in interest rate, which has meant that the investors, in order to hedge their exposure to interest rate, have started investing in these categories.

I have heard a lot of guests talk about Target Maturity Funds. Can you tell us a bit about Target Maturity Funds and why are they so popular?

Piyush Gupta: This is a category where the fund first identifies an index, which they would want to replicate as part of (their) portfolio. Now, if you look at a lot of the Target Maturity Funds which have come in, they have an underlying either in the form of government security, state development loans (SDL) or public sector undertakings (PSU) corporate bonds.

If you were to look at the underlying, it is slightly on the safer side. From the credit quality perspective, the credit quality is superior. Given the current market condition, in the last couple of years, there is an expectation from the investor to have a more secure portfolio and to avoid any kind of event in terms of downgrade or default. So, that is a big factor.

Secondly, in an actively managed fund, you can have a situation whereby while the portfolio could be of a certain credit quality, it can change over a period of time, where there is also a discretion that the fund manager may exercise when it comes to constructing a portfolio.

In case of Target Maturity Funds, the portfolios are essentially driven by the underlying index, and these underlying indices largely have a defined mandate.

It could be that they would be having underlying securities in the form of G-Sec, SDL, Corporate Bond PSUs, which means that you will have less chances of any kind of a style drift in the portfolio. So that is one aspect.

Second is an interest rate scenario. We have seen that interest rates are inching upward and there is an expectation that interest rates can go further up.

In that scenario, if you were to enter into a Target Maturity Fund which follows the roll down strategy, or where the duration of the portfolio will be at a certain level at a given point in time. When the investor is entering the portfolio at a given point of time, and if interest rates are at a high level, he sort of is able to lock in that interest rate prevailing at that point of time.

Also, these funds are open-ended. Three years down the line, there is a mark-to-market gain that would have got realised in the portfolio. At that time, he also has an option to exit by booking those mark-to-market gains. And with a three-year taxation, it makes all the more sense to participate in Target Maturity Funds.