If you’ve been following the news lately, Bajaj Finserv and Zerodha have recently got in-principle approval by SEBI to set up their AMC’s to launch mutual funds.
So what does a mutual fund do? How does an AMC work?
Alongside getting answers to these questions, we will try and do a deep dive on HDFC AMC.
Of late, with the offtake in financialization of savings coupled with a low interest rate regime, mutual funds have been thriving with inflows and NFOs.
Let us try and dissect a few basics of the Mutual Fund Industry.
What’s a Mutual Funds (MFs) value proposition?
Fundamentally, MFs enable people and entities, who cannot for varied reasons actively manage their investments in market instruments, to invest in the market by handling the investment and management of their funds.
Though large entities also park their funds in MFs, the MFs are inherently known to be a way for the common man, who is unaware of the nuances of stock / bond picking, to participate in the market by getting a fund to take investment decisions on his behalf.
The investor is required to pick a fund based on the match between a fund’s mandate and his / her investment goals.
How do MFs operate?
MFs sell units to investors.
Each unit represents a share in the total AUM of the MF. The value of these units is primarily derived from the value of the AUM.
Investment gains / losses on the AUM get reflected in the value of the Assets of the MF and ultimately on the Net Assets. The Net Assets divided by the number of units gives the value of each unit, popularly known as ‘NAV per unit’.
Typically, units can be bought and sold by the investors and the transaction price gap represents the investor’s gain / loss. Investors may also get income from the MF in the form of dividends. So, a single unit of the MF represents a pro-rata stake in the net assets (scrips and instruments in which that MF / scheme has invested) of the scheme of the MF.
How do MFs make money?
To understand broadly, MFs charge two kinds of fees from the investors of their fund –
- Management Fees – This fee is typically a fixed % of the Asset under management (AUM) and is charged from the investors irrespective of the performance of the investments.
- Performance Fees – This is charged provided the MF attains a pre-determined threshold of performance. It is typically a % of the performance over and above the threshold but can also be a % of the AUM. The thresholds could be absolute % or could involve beating the benchmark of the concerned MF. (Typically, these are a characteristic present in PMS, or codified into the salary structure of fund managers.)
- Other Income – The surplus (after meeting expenses and other obligations) portion of the fees that a MF earns is deployed by the MF to earn returns.
What does it cost the MF to run the show?
MFs work on an asset light model.
The USP of the business model of AMCs is largely the fixed nature of expenses.
As their main outflow, AMCs primarily have employee costs, agent / channel partner commissions and administrative costs of running office spaces across the country.
The bulk of these costs grow only linearly despite the exponential increase in revenues on account of the galloping AUM.
Think of it this way, a 10x increase in AUM doesn’t warrant a 10x increase in Fund Managers nor a 10x increase in office space. In fact digitalization of the entire AMC value chain is making ripe the possibility of de-growth in office administration costs.
Even when it comes to the Carry (incentive) of the fund managers, it is minuscule compare to the fee income (revenues).
Thus, the operating profit margins of HDFC AMC have grown at a CAGR of ~14% between FY16 and FY20, against a ~9% CAGR in Revenues.
With the basics of MFs understood, let us note the key drivers for the Indian Mutual Funds Industry (IMFI) –
- Financialisation of surplus funds
- Regulatory Landscape
- Executive Compensation
We will delve into nuances of each of these elements:
Appreciating IMFI’s performance thus far and the scope ahead
The Average Assets Under Management (AAUM) for June 2021 and AUM as on May 31, 2021 of the IMFI stood at around ₹ 34 trillion. To understand the scope of financialisation in India it is equally important to appreciate how far the IMFI has come over the years.
- The above mentioned AUM has grown from ₹ 6.73 trillion as on June 30, 2011 – more than 5x increase in a span of 10 years, with the last 5 years accounting for ~60% of the increase.
- The milestone of ₹ 10 Trillion in AUM was achieved in May 2014 after an inconspicuous growth over the 1st decade of the century. However, it took only around 3 years each to clock the next two ₹ 10 Trillion (power of compounding working in true sense)
- The MF industry has crossed a milestone of 10 crore folios during the month of May 2021 with more than 1 crore portfolios being added in the last 12-15 months. There are around 2.4 crore unique investors as on June 30, 2021.
So, having glanced at the journey until now, we can attempt to very broadly appreciate the scope or opportunity that lies ahead.
The just 2.4 crore unique investors vis-à-vis an approx. 92.5 crore adults upto age 65 (with approx. 32 crore of them living in urban areas) shows that the penetration is still in its infancy despite the rocketing growth over the last decade.
Besides, the number 2.4 crore also includes artificial persons and not just individuals and this fact magnifies the future scope even more.
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The reason we are emphasising on the untapped market in terms of population is because MFs aim to channelize the savings of the masses into the markets. So the large untapped population together with the typically high saving mentality of the average Indian, lays before us the massive amount of surplus funds lying in bank accounts, FDs, gold, post office investments, etc. which can be channelized by the IMFI into the markets.
India has one of the highest savings rate in the world!
Navneet Munot, the newly appointed MD & CEO of HDFC AMC, said in Q4’FY21 earnings call – “The industry that we represent has seen phenomenal growth, especially in the last six, seven years. Though if you look at long term growth potential, it looks like we have just scratched the surface. So, I feel very optimistic about our industry.”
Driver I – Financialisation of Surplus Funds
There has been a ~34% (~51% in Equities segment) YOY growth in the Quarterly Average AUM (QAAUM) of the IMFI in QE June 21. Majority of the growth in Equity AUM is coming from the regions beyond the top 30 geographical locations thereby showing that the coverage of AMCs is widening into the smaller towns.
Some of the major drivers of the flourishing financialisation of surplus funds in India are –
- Low interest rate regime
- Mutual Funds Sahi Hai campaign
- New-Age Investment Platforms viz., Coin, Groww, Paytm
This is what Mr.N. Munot, MD & CEO, HDFC AMC had to say in the Q4’FY21 con-call – “In fact, in the last one year, almost more than 1/3rd of the new investors that the industry has added have come from these fintechs. Also, another interesting aspect is that a lot of these new investors are actually less than 30 years of age”
Work From Home (WFH)
WFH since the last 15 odd months has resulted in a sizeable increase in the savings of white collar professionals in the form of reduction in commuting expenses, outside food, etc.
So this surplus money is finding its way into MFs boosted by the increasing acceptance of equities as a path to superior wealth creation (quantification of this driver is a little difficult, albeit being a small proportion)
Driver II – Regulatory Landscape
As the MFs are known to be the fund managers of the masses, they have to work in a well regulated environment that is designed with the objective of protecting the interests of the masses by putting up controls to prevent reckless, mis-managed actions as well as ensuring transparency, efficiency and standardisation in operations.
So, the idea behind having a well-regulated landscape is to put the industry into a virtuous cycle where the regulations get the MFs to adopt best practises which in turn kindles faith in the masses for the MFs, basis which they agree to entrust their funds to the MF which then repeats the process.
In India, the market regulator SEBI is primarily the maker and enforcer of regulations for MFs. Right from issuing licenses to start shop to shareholding and governance norms to roles of custodians to operational (allotment, transfer, listing, merging / splitting, scheme designing) aspects of the MFs, SEBI has engraved regulations for it all.
Often in the spotlight is the regulation regarding Total Expense Ratio (TER) at MFs.
TER is a measure of the total costs associated with managing and operating a MF. These costs consist primarily of investment management fees, and additional expenses, such as distribution costs, trading fees, legal fees, auditor fees, and other operational expenses. The total cost of the scheme is divided by the scheme’s net assets to arrive at the TER for that scheme.
Why is TER important?
On the regulatory front, SEBI mandates ceilings to the TER for different kinds of MF schemes having regard to the level of AUM. This regulation is something which investors relay a keen focus on as well because it impacts their return. So, the returns the MF generates on the AUM is first used to absorb the expenses incurred by the MF and the surplus is what the return is for the investors. Thus, putting a lid on the TER seeks to ensure that the MFs are prudent with their expenses.
As on 23rd July, 2021), the TER limits for Open Ended schemes other than Fund of Funds, Index Funds and ETFs are as follows –
A 30bps higher allowance of TER is permitted provided the scheme achieves certain targets around garnering investments from people in B30 (other than the top 30 geographical locations) regions.
As per the current SEBI Regulations, MFs are required to disclose the TER of all schemes on a daily basis on their websites as well as on AMFI’s website.
TER limits for other kinds of schemes can be found on Regulation 52(6) of the SEBI (MFs) Regulations, 1996.
Driver III – Executive Compensation
In 2018 when HDFC AMC listed on the bourses, a news grabbing eyeballs was that many of the entity’s senior employees had become overnight millionaires. With the value of holdings of the then CEO and CIO crossing Rs.150 crores. So this headline begs the question of how these executives came to be so deeply invested in the company.
Firstly, a decent portion of the executive compensation is in the form of ESOPs which results in the executives owning sizeable shares.
However, ESOPs eventually tend to loose their sheen as a motivator to outperform and to handle this comes in Carry. Carry represents the variable compensation of the senior executives in the investments arena – AMCs, PEs, VCs, etc.
Typically, carry is a % of the Alpha (outperformance over benchmark or any predetermined threshold) that a fund manager generates. This compensation motivates the fund manager to generate good performances. Having said that, Carry has a ceiling to prevent reckless actions on the part of the managers as well.
A recent exciting development w.r.t Executive Compensation happened in April 2021 when SEBI issued a circular regulating fund manager compensation. This move by SEBI is popularly referred to as “Skin in the game norms” in industry circles.
The new rule makes it compulsory for top officials of MFs to invest 20% of their salaries in their own schemes i.e. get 20% of the salary in the form of units of scheme.
For Fund Managers, it’ll be 20% in terms of units of the schemes they manage, for other Key Officials, it’ll be 20% in terms of units all schemes of the MF other than passively managed and close-ended schemes.
To add to the above, there is a 3-year lock in (except if the fund winds up) from the date of allotment of the above mentioned units.
The idea behind the move is that some fund houses take excessive risks while chasing returns, thus possibly jeopardizing the prospects of schemes managed. SEBI wants to make sure that the interests of the fund managers are aligned to those of the unitholders.
It is also important to note that it not only the fund managers who will be impacted by this, rather the entire cohort of “Key Officials” which includes the likes of the CEO, CIO, CRO, HODs.
Also, if any of these executives are ever found guilty of any wrong-doing, appropriate reparation will be derived from selling their units.
As on July 23, 2021, on account of more time being sought by the IMFI, SEBI has deferred the due date for implementing these norms to Oct 1, 2021 from July 1, 2021.
Consistently stiffening of the TER Cap by SEBI
While the MFs have managed to accommodate the stiffening TER caps until now, it is anybody’s call as to how long they would be able to fit in without compromising on service quality.
Switch to passive funds
Admitting to the shift, Mr. N Munot (CEO & MD, HDFC AMC) in the Q4’FY21 earnings call said – “Surely over the last few years, we have witnessed globally that margins in this industry have been under pressure, a lot of money has been moving towards passive, which has led to like consolidation in the industry”
While it is well known that equity investments should be made for a long term to reap the benefits of compounding, the average duration of investment in AMCs is just about 2.5 years. While the rising market frenzy brings droves of investors inside, a falling market risks doing the opposite.
HDFC AMC is one of the largest and most profitable mutual funds in the country.
Incorporated at the cusp of the millennium (Dec 1999), it has been acting as the AMC to HDFC MF since the last ~21 years.
It has other SEBI licenses viz. PMS / AIF. HDFC AMC operates as JV between HDFC Ltd and Standard Life Investments Ltd with holdings of 52.69% and 21.24% respectively.
The company has a diversified asset class mix across Equity and Fixed Income/Others. It also has a countrywide network of branches along with a diversified distribution network comprising Banks, Independent Financial Advisors and National Distributors.
The company is the most profitable AMC in India (in terms of net profit) since FY13 and is among the top 3 in terms of AUM.
HDFC AMC has a highly experienced investment management team. In fact, a good number of them have been with the organization for a long time / since inception. Prashant Jain, who’s been a veteran in the industry for almost three decades now, leads the highly talented investment team.
Their revenues have grown at 9% CAGR between FY16 and FY20 while the expenses have de-grown at a CAGR of 11% in the same period, resulting in their PBT clocking a ~24% CAGR. In FY21 revenues have fallen by 8% on account of the increased redemptions in the wake of the Covid-19 induced crash in March 2020.
Their recurring Other Income (considering only Investment Income) has increased from Rs.48 crore in FY16 to Rs.255 crore in FY21. So as company generates more AUM, it receives more fees, which it invests (in say liquid funds, shares, etc.) and generates Other Income. To better appreciate the money churning machine that the company is turning into in the form of investment income we must note that the above Rs.255 crore is around 56% of the company’s expenses. So, around half of the expenses are being taken care by such other income itself. This was <10% in FY16. If this dream machine continues, there may in the next 7-8 years come a point where the Other Income sufficiently covers the expenses and the entire revenue flows to the pre-tax profit.
The Balance Sheet of the company is clean with Reserves (Liabilities) and Investments (Assets) accounting for ~92% and ~95% respectively of the total Balance Sheet at end of FY21. ~74% of these Investments are invested in MFs in the Liquid and Debt space and ~11% directly in Bonds. So, the overall investment profile is that of a stable income generator.
HDFC AMC is among the top 3 cos. in terms of overall AUM. On an overall basis the market share in QAAUM of the company has remained stable at ~13-14% over FY21.
However, in actively managed equity oriented space, its market share has been slightly (15% to 13%) reducing since FY21. Having said that, it is encouraging to note that the Equity QAAUM as a % of Total QAAUM has grown at 14% (11% for Industry) YoY in Q1’FY22 thereby signifying the management’s intent to focus more on equity.
It has performed very well in debt space. Its market share in QAAUM in debt category has increased by ~200bp YoY in Q1’FY22. HDFC AMC is clearly recognising and acting on its strength in the Debt space as is evident from the following points –
- A 1000 bps (100 bps for Industry) YoY increase in Q1’FY22 in share of Debt in total QAAUM of the company.
- Considering QAAUM for Q1’FY22, Debt is 38% (33% for Industry) of the total QAAUM.
As far as the entire industry is concerned, in terms of the breakup of the AUM, in FY21, the YoY Net Sales has increased for Debt from – Rs. 365 bn to Rs.2,200 bn. However, the same has reduced for others – Equity and Liquid funds due to redemption pressures on account of 1) withdrawals when the sentiments fell in March 2020) profit booking when markets recovered handsomely in later periods of FY21.
Liquid Funds is the area where the company has seen strongest dent in its market share. However, this doesn’t seem to be a sign of worry basis the following remarks by Navneet Munot, CEO & MD, in the Q1’FY22 earnings call
“We had a significant increase in our market share in liquid. I mean, when there was a crisis around March and April, obviously, money moved to safe havens and we got higher flows within the liquid fund. But as the corporate requirement of money has gone up over the quarters, I mean, the overall
AUM in the liquid fund category has come down for us. And now our market share is more reasonable there, I mean, it was exceptionally on the higher side last year.
The company has consistently had a higher (compared to the industry) % of its QAAUM in Liquid Funds. HDFC Bank’s rich CASA franchisee is leveraged by HDFC AMC and thus it is the MF of choice when it comes to investing in Liquid Funds by such CASA beneficiary.
It is the leader in terms of Individuals’ AUM. However, its lead has slightly thinned in YTD Q1’FY22. However, so has been the case with 3 of the top 5 AMCs.
Individual Assets Market Share – HDFC AMC vs the competition
Source – HDFC AMC’s Investor Presentation for Q1’FY22
The company has adopted digital solutions across its value chain to a great extent such that the share of electronic transactions has increased from 36% in FY16 to 85% in Q1’FY22.
The management expects to launch a variety of funds in the coming six months to make up for the lost market share across several categories like Large Cap, Flexi Cap, Equity, Hybrid, and ELSS.
Navneet Munot, CEO & MD, admitted in Q4’FY21 earnings call – “So, on the thematic and sector side, on the passive side, as well as on the international side, we have some gaps, which we would like to fill over the next several quarters.” In fact Mr. Munot has stated the following as one of his key objectives after assuming the role of MD & CEO – “..we have seen loss in market share in some of our key categories. As far as equity is concerned, I think we would like to stem that fall and start rebuilding that market share. We have grown our market share on the fixed income side, but still we think given our brand and a long-term track record and the quality of people we have, still there is scope for us to grow there.”
HDFC AMC has remained amongst the Top 2 players in the previous five fiscals. It is a trusted brand with strong parentage. The company focuses on individual customers and customer centric approach. The management hasn’t shied away from acknowledging that there have lost market share in multiple categories and have been forthcoming with their intentions to launch a variety of schemes to make up for the lost ground. As far as the threat of short term underperformance is concerned, the management seems to be un-swayed by these pressures and rather believes in sticking to its time tested strategies which have given industry beating returns in the past and the this mindset seems to bear fruit as over the last six months or so. However, this is not to say that the company is closed to new styles, the addition of two new fund managers with a different focus on valuations is an attempt to achieve style-diversity. Having said all this, the company given its goodwill and resources is firmly placed to make the most of the flourishing financialisation of savings in India.
Every Sunday, member of The 0.01% club come together to brainstorm on a detailed investment thesis. Click here to find out more about the membership plans.
This article was made possible because of Anuj Poddar.
Anuj worked extensively on getting the framework of this article up and running alongside incorporating relevant edits.
Anuj is a recently qualified rank-holder Chartered Accountant and has completed all levels of CFA Program, USA. He has worked at EY during his Articleship. He is fond of knowing about businesses – with an emphasis on appreciating factors which contributed to some businesses prosperously sustaining for many decades while some some others failing the test of time. Anuj acknowledges “Compounding” as the eighth wonder of our world. While nurturing this fondness of knowing businesses, taking help from his professional education and practical assignments, he aspires to become a skilful value investor.
This is the first of deep dives re-published for all. The initial presentation was made on 21st November, 2020. You can access the same here.
Access all previous and future deep dives here.