Stock Story : HDFC Asset Management Company

The asset management industry in India is one of the very few industries that has both grown at a sweltering pace and still remains under-penetrated. How under penetrated? Really, really under-penetrated. This infographic should drive that point home.

Asset management industry in India - Landscape

But before we go into the details, let’s take a step back and understand the asset management industry landscape. Mutual funds are at the heart of this industry. This is what the eco-system really looks like.

There are 42 different fund houses offering over 1700 different schemes. But, have you ever wondered why we have such a massive variety of schemes?

Before we answer that question, here’s something else for you to think about. How much was your electricity bill last month? How much was your insurance premium? You probably have a vague idea. How much fees did you pay on your mutual fund investments last month? Chances are, you don’t know. The reason is because mutual funds are in one of the most privileged positions of charging you a fee without actually sending you an invoice and asking you to pay for it. They have something called an expense ratio which varies depending on the size of the scheme.

Mutual funds in India - SEBI mandated fee structure

The SEBI in India publishes the rate card that mutual funds have to stick to. This rate card, also known as TER or Total Expense Ratio, is a % on the scheme’s total funds (AUM) the MF will charge you as fee. It works something like the income tax slab, except that this TER % goes down as the scheme becomes bigger. Here are the current rates.

If you are a fund house and you are given a choice between having 200 different schemes with 100 crores in AUM each and having one scheme with 20,000 crores in AUM, you should obviously prefer the first option. This, my friends, is primarily why we have such a large number of mutual fund schemes.

Mutual fund houses in India

Now, while the number of schemes offered, and the assets managed by the industry have both increased, the number of fund houses who are in the business has not gone up at all. This graph shows how their numbers have changed over the last decade and it is more or less unchanged.

Why is that?

This is because one of the key success factors to doing well in this business is SCALE. The big become bigger and the small remain small or leave. The industry is also quite concentrated. The top 6 players in the industry today control close to 2/3rds of all the money invested and they have gained a full 10% additional market share in the last 7 years.

Why scale matters in the asset management industry?

Up until 5 years ago, the top 5 mutual funds made more than 100% of the entire industry’s profits.That meant that most of the bottom 35+ mutual funds made nothing but losses. Today that figure is still over 90%.

Charlie Munger once asked a bunch of students to call out a situation in which increasing price leads to increased sales. The financial nerds amongst them said, “The luxury goods business”. And they were right. “But there is one more situation”, he said. “It is when the seller increases the price to pay a higher bribe to the buyer’s purchasing manager”. The whole room burst out into laughter. But the truth of the matter is, that is exactly what is going on in the mutual funds’ distribution business. Financial advisors, who are supposed to be OUR purchasing managers for mutual funds, have been pushing schemes to us that offer them higher commissions. And if you think about it, it is SCALE that gives the large mutual funds the ability to promote their schemes aggressively by offering higher commissions and incentives to distributors and financial advisors. In addition, large fund houses can afford to pay a premium and hire the best of the best fund managers from the market.

Given the restricted bandwidth smaller MFs have, it isn’t going to be practicable to offer a wide variety of schemes either. For instance, Parag Parikh Financial Advisory Services Limited, one of the smaller AMCs offers 3 schemes. Contrast that with HDFC’s 120+ schemes in offer as of March 2020!

But there is one more key advantage that scale brings in – Large MFs tend to have large distribution networks offering them the highest chance of being able to capture new funds from investors. And who do you think has the widest and deepest distribution network in the country? – The Banks! Their branch infrastructure is so wide, and their brands so well established in the financial services industry that they have remained the most successful AMCs in India. 4 of out the top 6 mutual funds are also banks. HDFC alone has 70,000 distribution partners across the country!

HDFC Asset Management Company

You’ve probably guessed by now that HDFC AMC is an extremely successful fund house. And you are right. Here is a look at their AUM, revenue and profits over the years.

As on date and amongst the over 5000 companies listed in the Indian stock market, there are only about 25 companies that have generated a return on capital employed (ROCE) of >50% in the last 3 years. And HDFC AMC is one of them.

HDFC AMC - Sources of income

Actively managed funds attract a higher fee than debts funds or passively management index funds. While actively managed equity funds are only about 40% of HDFC AMC’s AUM, over 75% of their revenue today comes from them. So it is important that we understand how equity markets can affect this chunk of the revenue they make.

The double whammy

When equity markets go up, the total AUM with HDFC AMC goes up. In addition, retail investors tend to invest more money when the markets are trending up and consequently AUM goes up even faster. So, in a bull market, revenue and profits tend to grow much faster than growth in stock prices. The exact opposite is true in a bear market. And mutual funds like HDFC AMC don’t like this double whammy during bear markets. While controlling the bull and bear phases of the market itself is beyond them, they have been working hard to stabilise fund inflows from retail investors.

Enter, SIP (Systematic investment plan)

Read our covery story on Mutual Funds – Where to start?

In the AMCs world, SIP is the name of the game. Look at every single advertisement on mutual funds. They are almost always about SIPs. Here are just some of the advertisement campaigns that HDFC launched last year.

  1. SIP to upgrade your lifestyle (KyaPlanHai)
  2. Har muhurat SIP ha muhurat
  3. Investing regularly keeps your finances healthy

But why do they focus so much on it? – Sure, it is good for us investors. But what do they get out of it?

SIP gives the company a very stable source of funds inflow that increases their AUM and revenue. HDFC’s AUM and consequently revenue grow by 4% each year just because of inflows through SIP. So, if the markets go up by 10%, their AUM and revenue goes up by 14%. But if the markets go down by 10%, the reduction in AUM and revenue will go down only be 6%. You see why SIP Sahi Hai applies to them too?

Are we forgetting anything else? Oh yes, the actual underlying mutual fund schemes themselves. And this is where the story takes a wrong turn.

HDFC AMC's mutual funds - How have they performed?

How does one grade the different schemes in terms of their performance?  You see, every MF scheme defines a benchmark for itself against which its performance is compared. For instance, HDFC’s top 100 fund compares its performance against NIFTY. The key objective of the fund manager (FM) is to deliver better returns than the benchmark. When the FM does, he/she has done justice to the fees the MF is charging. This is the premise behind active investing. If active investing isn’t even going to beat the benchmark, we might as well pay lower fees and invest in passive funds like ETFs or Index funds.

As of the end of August, over 85% of HDFC’s actively managed funds made lesser returns than their benchmark over a period of 3 and 5 years! Not even a single fund managed by their legendary CIO Prashant Jain managed to beat its benchmark. HDFC AMC’s market share in the cash-cows (equity MFs) has consequently taken a beating and has come down by about 1.5%. But there is much a larger trend going on here.

The upcoming era of AI-powered investing

Investors in the US are starting to realise that actively managed funds aren’t doing justice to the fees they are charging. A mass exodus of people is underway now from active funds to passive funds. AUM in such passive funds has gone up by 4X in the last 10 years to over $10 Trillion worldwide. While this trend hasn’t really caught up in India yet, it might just do as investors become savvier and start asking the right questions. And when that happens, revenue and profits for the industry as a whole will start sagging.

Not just that, algorithms driven fund management is becoming a thing now. Artificial intelligence-powered funds are thrashing their indexes. The fund manager for AIEQ (AI powered equity ETF) is a model which runs 24 x 7 on IBM’s Watson platform. It assesses over 6,000 companies each day, scrapes millions of regulatory filings, news stories, management profiles, sentiment gauges, financial models, valuations and bits of market data to choose 30-70 companies for the fund! And it has performed exceptionally well! It has delivered 13% returns against its benchmark S&P 500’s 7% return.

The future may not belong to the AMC with the best fund managers. It may belong to the AMC with the best algorithm. The future may not belong to the bank with the widest distribution network, it may belong to the technology platform with the widest social media reach. And in such a world, HDFC AMC might just get left far behind. But till then, it might just remain as the white horse that people will bet on.

Disclaimer – I hold a tracking position in HDFC AMC’s stocks. My views may be biased. This is not a buy or sell recommendation for the stock. It is merely intended to be an educational column. Please consult with your financial advisor before investing.

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