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Trend Watch : Can mutual funds survive an upturn?

Mutual funds are shuddering at the prospect of an economic recovery. But they have enough time to consolidate their client base

The Smart Investor Team

Normally a recovery means good news for all, consumers, manufacturers and service providers. But hold on. Mutual funds aren't very enthusiastic, though. Why? Because, the biggest investors in the domestic mutual fund industry today are large corporates and banks.

These investors have put in more than 50 per cent of total assets of the industry. And, a recovery means that corporates may pull out their money to invest in their core activities. Similarly, a revival in credit demand on the back of a recovery means that banks may need to pull out their investments from mutual funds to meet the demand.

That's perhaps why mutuals are pulling such long faces at the prospect of a recovery. What if the economy recovers and corporates go on a spending spree? Capacity expansions, merger and acquisition activity and better credit demand would require corporates and banks to encash their existing investments to plough back in their core business.

Obviously, there is a strong possibility of large scale redemptions. While fund companies see this issue as a matter of concern, they are optimistic about guarding their current assets. Says Ved Prakash Chaturvedi, chief executive officer,

Tata TDW Mutual Fund, "Despite an economic recovery, the fund industry should be able to retain and in fact, grow its assets."

Is a economic recovery underway? The outlook on the economy is pretty much positive and economists are predicting a wide-ranging recovery led by an increase in domestic consumer demand.

According to the latest data released by the Central Statistical Organisation (CSO), the Indian economy grew 4.3 per cent in 2002-03. With the manufacturing and services sectors growing at 6.0 per cent and 7.1 per cent respectively, the poor performance of the agriculture sector dragged down the overall growth. Growth in the agricultural sector declined 3.2 per cent last fiscal. The growth in manufacturing industry was led by buoyant exports and a boost to construction activity.

This year, again, the manufacturing sector is expected to grow at a faster clip. The overall manufacturing outsourcing story should mean more business for Indian manufacturing companies too.

Construction is again going to be a key driver. So sectors like steel and cement have already seen a quantum jump in demand and many loss-making companies such as Ispat, Essar, and the Jindal group have turned profitable. Similarly, many other sectors such as consumer durables and textiles are seeing demand-led growth. Many of these corporate houses are thus focusing on the longer-term targets.

Some sectors like steel are already talking of capacity expansion and green field projects. Others like cement have been seeing consolidation. However, as Sanjeev Bafna, senior vice-president corporate finance, Grasim Industries says "It will take 1-2 years for the Indian industry to start committing funds into expansions."

But whenever it happens, will corporates queue up for redemptions? And secondly, will banks and financial institutions, which have invested their surplus funds in mutual funds on the back of poor credit offtake in the last couple of years, divert their money into lending?

The latter, of course, is a definite possibility. Last year, lending behemoth IDBI was among the biggest investors in mutual funds. Others such as ICICI bank and HDFC also figured in the list of biggest investors.

While Reliance Industries was one of the largest investors in mutual funds, mutual fund sources say that some of the other big investors are from the banking industry. For instance, both IDBI and SIDBI are said to have a considerable exposure in rolling over surplus funds in mutual funds. Other big players in the sector include the Finolex Group, ICICI Bank, Bank of India, Central bank and LIC Housing Finance.

Clearly, a lot depends on the outlook for the economy. Any revival will result in an increase in credit offtake and thus, funds will have to be redirected from the market to industry. But the probability of that happening in the near-term is bleak: there is a huge amount of liquidity in the banking sector, and further rate cuts will only add to it.

But corporate money pulling out may not be that big a threat. Here is why. Companies typically park their surplus cash in treasury instruments (liquid fund schemes). And, they deploy money considered surplus in a slightly longer horizon into medium term funds. Industry experts feel that the economic recovery will have no impact on the flows into liquid funds.

As a matter of fact, improved cash flow for corporates will only increase the popularity of liquid funds. Even more, they say that today financially healthy corporates will find it less prudent to pull out money from investments like mutual funds to fund expansions because borrowed funds are so cheap.

Also, capital expenditure is never lumped together but is spread over a period of time and prudence requires a judicious mix of debt and equity depending on the project size, horizon of returns, gestation period etc. Hence there will not be any sudden withdrawal of funds from the market. Such expenditure is planned in advance and as result, a company cannot take the risk of a sudden withdrawal of its investment.

Opportunity cost of money

To get a feel of this, look at the opportunity cost of money. Currently, companies have witnessed around a 500-600 basis points reduction in interest costs on long-term debt from about 16 per cent-plus in 1998-99 to about 10 per cent now, and even lesser for top rated corporates, which can raise money at around 5.5-6.0 per cent per annum. As a result, it is much more attractive to fund investments by taking on additional debt while continuing to earning a higher return from deploying internal cash into market instruments such as mutual funds.

Arbitrage between debt vs funds

But the main reason that the companies prefer raising debt is two-fold. Firstly, debt is available at historically low costs and secondly, tax considerations favour debt. These include a tax benefit on the interest costs, a dividend distribution tax on dividend income and capital gains tax on long-term capital gains. As a result, while effective cost of debt is less than 4 per cent, the effective tax-adjusted return on mutual fund investment is around 5-6 per cent.

Grasim's Bafna says "the biggest factor that will determine an outflow of funds is the any change in the tax status of dividends and capital gains tax on long-term capital gains". Currently, dividends from mutual funds are tax-free in the hands of the investors except for a dividend distribution tax of 12.81 per cent. Long-term capital gains are taxed at 10.25 per cent with indexation benefits, and at 20.5 per cent without indexation benefits.

The banking sector, with the considerable amount of liquidity in the system, has also been a significant investor in mutual funds.

For instance, as on March 31, 2003, HDFC had investments of around Rs 1500 crore in liquid funds. According to MA Ravi Kumar, Regional Head - Global Markets, Stanchart Grindlays "The corporate sector accounts for a reasonable chunk of the investments in mutual funds. While there may be some withdrawal of funds, an increase in economic activity will also increase the surplus funds. Therefore, over a period of time, the cash surpluses will find their way back into the market"