Mutual Funds and Market Development in India*

posted 8 Jul 2011, 04:26 by CA Naresh Shah

Financial sector development can be viewed as a process that enhances four critical attributes of the financial system: efficiency, stability, transparency and inclusion. The emergence of intermediation mechanisms and products that help improve on one or more of these without causing others to weaken are, therefore, a meaningful indicator of financial development.

From this perspective, Mutual Funds play an important role in the development of the financial system. First, they pool the resources of small investors together, increasing their participation in financial markets, which helps both inclusion and the efficient functioning of markets themselves, as a result of larger volumes. Second, Mutual Funds, being institutional investors, can invest in market analysis generally not available or accessible to individual investors, thereby providing services based  on informed decisions to small investors. Decisions made on the basis of deeper understanding of risks and returns contribute to financial stability, besides helping to mitigate market risk for this group of investors. Third, transparency in investment strategies and outcomes, though typically mandated by regulators, is relatively easy to deliver on, so that investors can find out exactly where they stand with regard to their investments at any point of time.

As far as regulation is concerned, Mutual Funds cut across domains. The Reserve Bank of India regulates three categories of financial markets; money markets, government securities markets and foreign exchange markets. Mutual Funds have a presence in the first two and the Reserve Bank is therefore interested in the role that they play in developing them. In what follows, I shall provide a brief description of the role of Mutual Funds in these two critical markets and discuss some of the regulatory issues that arise. I shall then make some more general comments about the role of Mutual Funds in financial inclusion.

II. Mutual Funds and Market Development

Mutual Funds have contributed significantly in broadening and deepening of different segments of the Money Market and, to some extent, the Government Securities market. Money Market Mutual Funds (MMMFs) were introduced in India in April 1991 to provide an additional short term investment avenue to investors and to bring money market instruments within the reach of individuals.

The guidelines for MMMFs were announced by the Reserve Bank in April 1992. The Reserve Bank had made several modifications in the scheme to make it more flexible and attractive to banks and financial institutions. These guidelines were subsequently incorporated into the revised SEBI regulations. In October 1997, MMMFs were permitted to invest in rated corporate bonds and debentures with a residual maturity of up to one year, within the ceiling existing for Commercial Paper (CPs). The minimum lock-in period was also reduced gradually to 15 days, making the scheme more attractive to investors.

MMMFs have witnessed phenomenal growth over the period. As on May 31, 2011, the total assets under management of the MMMFs was placed at Rs.1,83,622 crore1, 25 per cent of the aggregate assets under management of the Mutual Funds.

In order to promote retail holding in government securities and broaden the investor base, Mutual Funds which invest exclusively in government securities, Gilt Funds, were introduced. The first Gilt Fund in India was set up in December 1998. However, Gilt Funds have registered moderate growth. As on May 31, 2011, the total assets under management of the Gilt Funds was placed at Rs.3,336 crore2, 0.5 per cent of the aggregate assets under management of the Mutual Funds.

Mutual Funds occupy a large share of the primary market of Certificates of Deposit (CDs) and CPs. As on June 10, 20113, the total holdings of Mutual Funds in CDs and CPs remained at Rs.2,95,164 crore (66 per cent of the aggregate outstanding) and Rs.82,951 crore (65 per cent of the aggregate outstanding) respectively. Mutual Funds have also provided substantial liquidity to the secondary market segments of CPs and CDs. Their increased activity in the secondary market corresponds to their growing portfolio of money market investments. During the last six months, MFs' share in the daily turnover the secondary market of CDs and CPs stood at around 41 per cent and 46 per cent respectively.

The overnight segment of the money market has also benefitted from the participation of Mutual Funds. Their reliance on the collateralized segment of the overnight markets, viz. market repo and Collateralized Borrowing and Lending Operations (CBLO), for placement of their daily surplus liquidity enhanced the depth of the markets.

By contrast, in the Government Securities market, the participation of Mutual Funds has not been very encouraging. Of the outstanding Government of India dated securities4, the Mutual Funds held 0.9 per cent as at end December 2010, which dropped to 0.2 per cent as at end March 2011. The average holding of government securities by the Mutual Funds during the last two years remained at 0.6 per cent as against 38.7 per cent by the banks, 22.4 per cent by insurance companies, 8.9 per cent by PDs, 6.7 per cent by PFs, 3.1 per cent by corporate entities. During the current calendar year till end of May, the average share of Mutual Funds in the secondary G-Sec market remained at 5.8 per cent of the total traded volume. One possible reason for the lower level of participation of Mutual Funds in the G-Sec market is lack of investor interest in the gilt-oriented Mutual Funds due to significant interest rate risks.

CA Naresh Shah,
8 Jul 2011, 04:28