What drives Indian retail investors when picking mutual funds?

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With nearly 38 trillion assets under management (AUM) and 13.13 crore investor folios as on 30 April, mutual funds (MF) in India now occupy a prominent position among financial intermediaries. The last five years witnessed an explosive growth in them. On an average, 12.53 lakh new folios have been added every month since April 2017.

Another noteworthy trend is in the increase in the share of equity schemes in the overall AUM. Equity-oriented schemes account for 49.6% of the industry assets as of April 2022. These schemes derive 88% of their assets from individual investors (retail and high networth individuals). Investments in equity can be made through active or passive managed portfolios. Though passive funds are garnering momentum in Indian markets, they still have a long way to go in India as compared to the developed markets. Most mutual fund (MF) investors in India allocate their savings to actively managed MFs, which seek to beat the market through some combination of fundamental and/or technical analysis.

Investment in active funds is always made in the hope of outperformance. Outperforming the benchmark is taken as an indication of fund managers’ skills. If investments are guided by past performance, it is reasonable to assume that investors would respond with more investments in funds that are outperforming the benchmark and penalize underperforming funds with withdrawals. And hence, consistent outperformance should lead to a higher AUM. However, this does not seem to be the case with Indian investors investing in equity funds. It can be observed from the table that the AUM of funds is not consistent with persistence of performance.

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MFs indicate their performance for a period of 10 years, 5 years, 3 years and 1 year and since inception. For our analysis, we consider the performance of various broad-based equity funds vis-à-vis their benchmark for four timelines (10 years, 5 years, 3 years and 1 year). The funds that are outperforming their benchmarks in all four or any three timelines are shown in the table. Performance data is as of 31 March and has been taken from AMFI.

As can be observed, in every case, barring one, funds having the highest AUM are not the ones that are consistently outperforming across the four timelines. This is in contrast to the findings in markets like the US. Investors in India do not seem to be chasing funds based on past performance. So, what drives their investment decisions?

It appears that the size of the fund family and longevity of the funds are more significant factors in driving investments into MFs. The AUM of funds seems to be more influenced by the overall AUM of the asset management companies. Investors appear to be buying funds that are easier or less costly for them to identify, that is, funds having lower ‘search costs’. These are generally the offerings from the large and well-known fund houses with more extensive distribution channels, marketing efforts, and receiving greater media attention. Large AMCs enjoy the benefits of lower search costs and MF schemes in large fund complexes grow more quickly. A combination of strong performance and lower search cost is lethal. Large AMCs enjoy a stronger response to good performance. Funds may also benefit from ‘performance spillover’, where funds enjoy halo effect from the other well-performing funds of the AMCs. There exists a possibility, that a section of investors who are well informed and savvy in their investment approach, are evaluating the funds on the basis sophisticated risk-adjusted returns measures.

MFs still appear to be push products. Large asset management companies that garner the spotlight by spending more on marketing and distribution attract higher AUM. Underperformance of funds is hardly given any visibility in marketing resources. Investor psychology is also a possible explanation for this phenomenon. Investors appear to be lazy to exit under performing funds. MF investment decisions appear to be ‘sticky’ in nature. Under these circumstances, AMCs have the incentive to spend more in reducing the ‘search costs’ for investors. Ideally, investors should ‘buy’ funds that meet their goals and objectives, match their risk appetite and perform consistently. However, they seem to be getting the popular products sold.

Dr Rachana Baid is professor at School of Securities Education, National Institute of Securities Markets (NISM). The views expressed here are personal.

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