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Role of Mutual Funds in India: An Empirical Analysis

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The Research Network, 4(4): (December 2009) ISSN 0975 0517

ROLE OF MUTUAL FUNDS IN INDIA: AN EMPIRICAL ANALYSIS

P. K. Mishra,1 K. B. Das2, B. B. Pradhan3

Abstract

The mutual fund industry in India has come a long way since 1964. From one player industry,
it has steadily progressed in the last forty five years to where it is today - thirty eight players
with average assets under management of Rs. 4933billion. The industry is now at the cross
roads of growth. It is of utmost importance that positive steps in the right direction are taken to
nurture the industry, which would go a long way in building a strong foundation that can
sustain growth through the transition from a maturing to a matured industry. The objective of
this background note is to touch upon the dynamics of the growth of mutual funds investment
which would evolve over the next few critical years. This paper examines the causality relation
that appears running between the growth of mutual funds investment and the development of
capital market in India. In the VAR framework and over the sample period from January 2000
to October 2009, the Granger causality test suggests the unidirectional causality running from
the growth of capital markets to the growth of mutual funds industry in India. Thus, the policy
makers should embark upon the reduction of volatility of Indian capital market and surge in the
capital market activities.
Keywords: Indian Mutual Fund Industry, Indian capital Market, Stock Market Returns,
Sensex, VAR Model, Granger Causality Test.

1. Introduction

Since the implementation of economic reform measures in 1991, the Indian economy has been opened up and many
developments have been taking place in the financial system of the country. Today, India‘s financial system is considered
sound and stable as compared to many other emerging markets. With progressive liberalization of economic policies, India
has witnessed a rapid growth of capital market, money market, and financial services industry including merchant banking,
leasing and venture capital. It is the financial market which channelizes the savings of the people into the productive
investment. Thus, financial market finances the economic development of a country. In this direction, the foreign investors,
local institutions and mutual funds play a significant role. During last few decades, the role of Indian mutual funds industry
as a crucial financial service in the financial market has really been noteworthy.
Mutual fund is an instrument of investing money. The Securities and Exchange Board of India (Mutual Funds)
Regulations, 1996 defines a mutual fund as a ‗a fund established in the form of a trust to raise money through the sale of
units to the public or a section of the public under one or more schemes for investing in securities, including money market
instruments‘. A mutual fund is thus, a trust that pools the savings of a number of investors who share a common financial
goal. Anybody with an investible surplus of as little as a few hundred rupees can invest in mutual funds. These investors
buy units of a particular mutual fund scheme that has a defined investment objective and strategy. The fund‘s manager uses
the money collected to purchase securities such as stocks and bonds. The securities purchased are referred to as the fund‘s
portfolio. The income earned through these investments and capital appreciation realised by the scheme are shared by its
unit-holders in proportion to the number of units owned by them. Thus, a mutual fund is the most suitable investment for the

1
Sr. Lecturer in Economics, Siksha O Anusandhan University, Bhubaneswar, Orissa, e-mail: pkm_iter@yahoo.co.in
2
Professor, Dept. of A & A Economics, Utkal University, Bhubaneswar, Orissa, e-mail: drkumardas@gmail.com
3
Professor and Registrar, Siksha O Anusandhan University, Bhubaneswar, Orissa, e-mail: registrar@soauniversity.ac.in
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common man as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively
low cost. The mutual fund is structured around a fairly simple concept, the mitigation of risk through the spreading of
investments across multiple entities, which is achieved by the pooling of a number of small investments into a large bucket.
There are many advantages of mutual funds. Mutual fund is a special type of institutional device or an investment vehicle
through which the investors pool their savings which are to be invested under the guidance of a team of experts in wide
variety of portfolios of corporate securities in such a way, so as to minimise risk, while ensuring safety and steady return on
investment. It forms an important segment of the capital market, providing the benefits of a diversified portfolio and expert
fund management to a large number, particularly small investors. Mutual fund investment increases the purchasing power of
investors. It ensures reduction in the transactions cost as the economies of operation are at a large scale. It facilitates money
management by professionals at a low cost. It is also convenient for the investors to invest the money also track the
performance of the money invested. It provides flexibility for the investor to change the investment objective. Therefore,
mutual funds play an important role in mobilising the savings of small investors and channelizing the same for productive
ventures in an economy like India.
1.1. Origin of Mutual Funds
The origin of mutual funds goes back to the time of the Egyptians and Phoenicians when they sold shares in caravans
and vessels to spread the risk of these ventures. However, the formal introduction of mutual funds dates back to 19th
century Europe, in particular, Great Britain. Robert Fleming set up in 1868 the first investment trust called Foreign and
Colonial Investment Trust which promised to manage the finances of the moneyed classes of Scotland by spreading the
investment over a number of different stocks. This investment trust and other investment trusts which were subsequently set
up in Britain and the US, resembled today‘s close-ended mutual funds. The first mutual fund in the US, Massachusetts
Investors‘ Trust, was setup in March 1924. This was the first open-ended mutual fund. The stock market crash in 1929, the
Great Depression, and the outbreak of the Second World War slackened the pace of growth of the mutual fund industry.
Innovations in products and services increased the popularity of mutual funds in the 1950s and 1960s. The first international
stock mutual fund was introduced in the US in 1940. In 1976, the first tax-exempt municipal bond funds emerged and in
1979, the first money market mutual funds were created. The latest additions are the international bond fund in 1986 and
arm funds in 1990. Since then this industry witnessed substantial growth with a significant increase in the number of mutual
funds, schemes, assets, and shareholders.
1.2. Growth of Mutual Funds in India
In 1954, the committee on finance for the private sector recommended mobilisation of savings of the middle class
investors through unit trusts in India. Thus, in 1963 the concept of mutual fund took root in India when Unit Trust of India
was set up with the twin objective of mobilising household savings and investing the funds in the capital market for
industrial growth. The Unit Trust of India (UTI) was the first mutual fund set up under the UTI Act, 1963, a special act of
the Parliament. It became operational in July 1964. The first scheme launched by UTI was Unit Scheme 1964 (US-64), the
first open-ended and the most popular scheme. And, by the end of 1988, UTI had Rs.6,700 crores of assets under
management.
Over a period of 25 years UTI funds grew fairly successfully and gave investors a good return, and therefore, in
1989, as the next logical step, public sector banks and financial institutions were allowed to float mutual funds and their
success emboldened the government to allow the private sector to foray into this area. Since then Indian mutual fund
industry had seen dramatic improvements, both quality wise as well as quantity wise. The late 1980s and early 1990s
marked the entry of public sector mutual funds set up by public sector banks and Life Insurance Corporation of India (LIC)
and General Insurance Corporation of India (GIC). SBI mutual fund was set up in June 1987 followed by Canara Bank
mutual fund in December 1987, Punjab National Bank mutual fund in August 1989, Indian Bank mutual fund in November
1989, Bank of India mutual fund in June 1990 and Bank of Baroda mutual fund in October 1992. LIC established its mutual
fund in June 1989 while GIC had set up its mutual fund in December 1990.
A new era was started in the Indian mutual fund industry with the introduction of private sector mutual funds in
1993. In January 1993, the first Mutual Fund Regulations by SEBI came into being, under which all mutual funds, except
UTI were required to be registered and governed. The erstwhile Kothari Pioneer (now merged with Franklin Templeton)
was the first private sector mutual fund registered in July 1993. Thereafter the number of mutual fund houses went on
increasing, with many foreign mutual funds setting up funds in India and also the industry has witnessed several mergers
and acquisitions. This significant growth has been aided by a more positive sentiment in the capital market, significant tax
benefits, and improvement in the quality of investor service.

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The Indian Mutual Fund Industry is one of the fastest growing segments of the Indian Economy. During the last ten
year period the industry has grown at nearly 22 percent CAGR. With assets of US $ 125 billion, India ranks 19th and one
of the fastest growing, among the countries of the world. The factors contributing to the growth of the industry are large
market Potential-high savings rate, comprehensive regulatory framework, favourable tax policies, introduction of new
products, role of distributors, investor education campaign, and past performance record.
The Indian mutual fund industry currently consists of 38 players that have been given regulatory approval by SEBI
(see Fig.1). The industry has witnessed a paradigm shift in favour of private sector players as the number of public sector
players reduced from 11 in 2001 to 5 in 2009.
Fig.1 Growth of Asset Management Companies in India

Source: AMFI data

From the plain vanilla equity and debt products we now have an array of different products such as thematic funds,
exchange traded funds, gold funds, capital protection oriented funds, funds based on analytical models and even funds
investing in overseas markets. Due credit for this evolution goes to the regulators for creating appropriate enabling
regulations for these products and the fund houses for effectively launching such products in the Indian markets.
The Indian mutual fund industry is in a relatively nascent stage in terms of its product offerings, and tends to
compete with products offered by the Government providing fixed guaranteed returns. As of December 2008, the total
number of mutual fund schemes was 1,002 in comparison to 10,349 in USA. Debt products dominate the product mix and
comprised 49% of the total industry AUM as of financial year 2009, while the equity and liquid funds comprised 26% and
22% respectively. Open-ended funds comprised 99% of the total industry AUM as of March 2009.
As of December 2008, the USA mutual fund market comprised money market funds, equity funds, debt/bond funds
and hybrid funds at 40, 39, 16 and 5% of the total AUM respectively. While traditional vanilla products dominate in India,
new product categories, namely, exchange traded funds, gold exchange traded funds, capital protection and overseas funds
have gradually been gaining popularity. As of March 2009, India had a total of 16 ETFs (0.3% of total AUM) while the
USA had a total of 728 ETFs as of December 2008.
Fig.2 Growth Rate across Product Categories
(CAGR from 2005 – 2009)

Source: AMFI data

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As on March 31, 2009 there are a total number of 4.76 crore investors accounts (it is likely that there may be more
than one folio of an investor which might have been counted more than once and actual number of investors would be less)
holding units of Rs. 419,321.66 crore. Out of this total number of investors accounts, 4.61 crore are individual investors
accounts, accounting for 96.75% of the total number of investors accounts and contribute Rs. 1,55,283.21crore which is
37.03% of the total net assets. Corporate and institutions who form only 1.21% of the total number of investors accounts in
the mutual funds industry, contribute a sizeable amount of Rs. 2,36,233.35 crore which is 56.34% of the total net assets in
the mutual funds industry. The NRIs and FIIs constitute a very small percentage of investors accounts (2.04%) and
contribute Rs. 27,805.10 crore (6.63%) of net assets. The details of unit holding pattern are given in the following table:
Table -1 Unit Holding Pattern of Mutual Funds Industry
(As on March 31, 2009)
NUMBER OF % TO TOTAL NET % TO TOTAL NET
CATEGORY INVESTORS INVESTORS ASSETS ASSETS
ACCOUNTS ACCOUNTS (RS.CRORE)
Individuals 4,60,75,763 96.75 1,55,283.21 37.03
NRIs 9,71,430 2.04 22,821.28 5.44
FIIs 146 0.00 4,983.82 1.19
Corporates/Institutions/Others 5,75,938 1.21 2,36,233.35 56.34
TOTAL 4,76,23,277 100.00 4,19,321.66 100.00
Source: SEBI Database
All this has prompted the mutual fund investors to come out of their comfort zone of fixed deposits and government
savings schemes with assured returns in search of green pastures in the form of additional returns. The trend is encouraging
and is drawing more and more participants to the investment management industry. Participants can visibly see the
underlying potential in the Indian markets and are keen to participate. But as competition intensifies and investors mature,
the challenges to growth and sustainability pose a major challenge to the success of the industry. Recent volatility in
markets, rising prices of commodities and the uncertainties in global and local political environments have dented the
capital market performance and the real threat lies in the ability of fund houses to deliver consistently irrespective of high
fluctuations and volatility in market conditions. Competition from other segments such as insurance and the good old
assured returns savings schemes, pose a competitive threat to the industry.
Capital markets all over the world were on a high for most part of the previous year when suddenly the pitfalls
emerged in the form of the infamous sub-prime crisis causing billions of dollars in losses to some of the biggest names in
the financial services industry. Fierce political battle lines were drawn in the world‘s largest economy and the world‘s
largest democracy, thereby causing political uncertainties. Global commodity prices and the resulting inflationary pressures
are giving sleepless nights to governments across the globe. India is no exception. With galloping inflation, slowdown in
industrial production and an uncertain political environment, the equity and debt markets have taken a beating. However
amidst all the global and local noises, wherein every analyst or research expert had only one advice...sell sell sell, the Indian
mutual fund industry was actually able to buck the trend and show an increase in assets under management.
The Assets under Management (AUM) have grown at a rapid pace over the past few years, at a Compounded Annual
Growth Rate (CAGR) of 35% for the five-year period from 31st March 2005 to 31st March 2009 (see Fig.3). Over the ten-
year period from 1999 to 2009 encompassing varied economic cycles, the industry grew at 22% CAGR. This growth was
despite two falls in the AUM – first in 2002-03 due to the dotcom bubble burst, and second in 2008 consequent to the global
economic crisis.
Fig.3 Growth in AUM in Indian Mutual Fund Industry
(Average AUM in Rs. billion)

Source: AMFI data

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India has been among the fastest growing markets for mutual funds since 2004. In the five-year period from 2004 to
2008, the Indian mutual fund industry grew at 29% CAGR as against the global average of 4%. Over this period, the mutual
fund industry in mature markets like the USA and France grew at 4%, while some of the emerging markets, namely, China
and Brazil exceeded the growth witnessed in the Indian market (see Fig.4).
Fig.4 AUM Growth Rate in Select Countries
(CAGR for 2004-08)

Source: AMFI data

However, despite clocking growth rates that are amongst the highest in the world, the Indian mutual fund industry
continues to be a very small market which comprises 0.32% share of the global AUM of $18.97 trillion as of December
2008.
The ratio of AUM to India‘s GDP gradually increased from 6% in 2005 to 11% in 2009 (see Fig.5). But it continues
to be significantly lower than the ratio in developed countries where the AUM accounts for 20 to 70% of the GDP.
However, India‘s low penetration level (AUM to GDP ratio) indicates significant scope for future growth.
Fig.5 AUM to GDP Ratio in India

Source: AMFI data

The tremendous growth of Indian mutual funds industry is an indicator of the efficient financial market we
are currently having. Now, the industry is playing a very significant role in channelizing the savings of millions
of individuals into investment in equity and debt instruments. Thus, resource mobilisation by mutual funds is an
important activity in the Indian capital market. India‘s mutual fund and capital market have witnessed
phenomenal growth over the last few years. Therefore, it appears that a kind of causal relationship is running
between the growth of Indian mutual fund industry and the growth of Indian capital market.

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It is with this backdrop, this paper aims at making an empirical study of the role performed by mutual
funds as a resource mobilizer in Indian capital market. The rest of the paper is organised as follows: Section 2
presents the data and methodology of empirical study, Section 3 makes the analysis, and Section 4 concludes.
2. Data and Methodology
The objective of this paper is to examine the role of Indian mutual fund industry in the growth of capital market of
India by investigating the causal relationship between the growth of equity investments by Indian mutual funds and growth
of stock market returns. Thus, we have considered two variables to test the aforesaid causality. The first variable is the ratio
of net mutual funds investment flows to BSE market capitalisation (MFI), and second one is the month-on-month stock
market returns based on monthly average of closing BSE Sensex (SMR).
The sample period considered in the study spans from January 2000 to November 2009 and consists of 119
observations pertaining to research variables.
Stock market return is the logarithmic difference of monthly average BSE Sensex of the last month from the current
 S 
month and is calculated by using the formula: SRt  Log  t  , where SRt is the monthly stock return on month ‗t‘, St
 St 1 
is the monthly average Sensex on month ‗t‘, and St-1 is the monthly average Sensex on month ‗t-1‘. For the sample period,
daily closing values of BSE Sensex 30, India‘s leading stock price index has been collected from the RBI database on
Indian economy, the most trusted data source. Sensex data doesn‘t have the observations on Saturday, Sunday and listed
holidays. Finally monthly averages are taken for analysis.
Net mutual fund equity investment flow is defined as the value of mutual fund investment inflows to equities in
Indian capital market less that of outflows from the market in a month. The data on monthly net mutual fund investment
flows have been collected from the archives of SEBI. The data on monthly BSE market capitalisation has been collected
from the RBI database on Indian economy over the sample period. Then the ratio of net FII flows in the Indian capital
market to BSE market capitalisation has been calculated.
The study employs the Granger causality test in the Vector Autoregressive Regression (VAR) framework. This
necessitates the empirical analysis to be performed in three steps: First, the stationarity test; second, the Cointegration test;
third, the Granger causality test.
The null and alternative hypotheses of the study and the VAR model formulated in this are specified as under.
H0: No causal relation between Net Mutual Fund Investment flows and Stock Market Returns
H1: Causality between Net Mutual Fund Investment flows and Stock Market Returns
n n
MFI t    i MFI t 1    j SMRt  j  u1t
i 1 j 1
n n
SMRt   i SMRt i    j MFI t  j  u2t
i 1 j 1

Where MFI is the ratio of net mutual fund investment flows to BSE marker capitalisation, and SMR is the BSE stock
returns. As is evident from the time series literature, the Granger Causality Test is very sensitive to number of lags included
in the model. In view of this, the Schwarz Information Criterion (SIC) for the selection of appropriate lag length has been
used.
3. Empirical Analysis
The Vector Auto Regressive model presumes stationarity of the research variables included in the model. So we
tested the stationarity as well as the order of integration of the variables using ADF unit root test. The descriptive statistics
and the ADF unit root test of the variables are presented in Table-2.

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Table 2: Descriptive Statistics and Unit Root Test of the Variables

Particulars MFI SMR

No. of Observations 118 118
Mean 0.035199 0.010377
Median 0.0000128 0.022272
Maximum 4.148676 0.193070
Minimum -0.001679 -0.278871
Standard Deviation 0.381913 0.072205
Skewness 10.72416 -0.729970
Kurtosis 116.0079 4.534535
ADF Unit Root Test (Levels) -6393.13* -7.5932*
*denotes statistical significance at 1% level.

The results show that Net Mutual Fund Investment Flow to the Indian capital market and stock market returns series
are stationary at levels indicating absence of trend and long run mean reversion. Thus, the variables are integrated of same
order, i.e., I(0). The results of Johansen cointegration test are summarized in Table-3.
Table 3: Cointegration Test of Variables

Sample: Jan 2000 to Oct 2009

Sample (adjusted): June 2000 to Oct 2009
Included observations: 113 after adjustments
Trend assumption: No deterministic trend
Series: MFI and SMR
Lags interval (in first differences): 1 to 4

Unrestricted Cointegration Rank Test (Trace)

Hypothesized Trace 0.05

No. of CE(s) Eigenvalue Statistic Critical Value Prob.**

None * 0.142115 28.01614 12.32090 0.0001

At most 1 * 0.090304 10.69491 4.129906 0.0013

Trace test indicates 2 cointegrating eqn(s) at the 0.05 level

* denotes rejection of the hypothesis at the 0.05 level

Unrestricted Cointegration Rank Test (Maximum Eigenvalue)

Hypothesized Max-Eigen 0.05

No. of CE(s) Eigenvalue Statistic Critical Value Prob.**

None * 0.142115 17.32123 11.22480 0.0038

At most 1 * 0.090304 10.69491 4.129906 0.0013

Max-eigenvalue test indicates 2 cointegrating eqn(s) at the 0.05 level

* denotes rejection of the hypothesis at the 0.05 level

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The Trace test indicates the existence of two cointegrating equations at 5% level of significance. And, the maximum
eigenvalue test makes the confirmation of this result. Thus, the two variables of the study have long-run or equilibrium
relationship between them. Now, the causality test can be performed to determine the direction of causation between these
two variables in the environment of VAR. This VAR model uses the lag length up to 5 as determined by Akaike
Information Criteria (AIC).
The results of the Granger Causality Test are shown in the Table-4. This table infers that the null hypothesis that
―MFI flows do not Granger Cause Stock Market Returns‖ is accepted and the null hypothesis that ―stock Market Returns do
not Granger Cause MFI flows‖ is rejected. This shows that the Mutual Funds activity of buying and selling equities in
Indian capital market are influenced by the movements in stock price index and stock market returns, but the reverse is not
necessarily true. Thus, higher stock market returns provides impetus to the flow of mutual funds investments in India.
Table 4: Results of Granger Causality Test
Lag Degrees of F-
Null Hypothesis Probability Decision
Length(AIC) Freedom Statistic
MFI flows do not Granger-cause Stock
2 224 0.7211* 0.4873 Accept
Market Returns
Stock Market Returns do not Granger-
2 224 3.6321* 0.0280 Reject
cause MFI flows
*The critical values of F for (2, 224) degrees of freedom at 1%, 5% and 10% levels of significance are 4.7011, 3.0361, and 2.3264
respectively.

Fig. 6 (a) Movement in BSE Sensex in India

20000

16000
BSE Sensex

12000

SENSEX
8000

4000

0
00 01 02 03 04 05 06 07 08 09
Year

Fig. 6 (b) Movement in Net Mutual Funds Investment Flows in India

8000

6000
Net MF Investment [Rs. crore]

4000

2000
NETMF
0

-2000

-4000

-6000
00 01 02 03 04 05 06 07 08 09
Year

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Fig. 6 (c) Movement in Stock Returns in India

.2

Sensex Based Stock Market Returns

.1

.0

-.1

-.2

-.3
00 01 02 03 04 05 06 07 08 09
Year
It is observed from the Fig.6 that the purchases and sales by mutual funds in India move in line with the movements
in stock market returns. This is the indication of the strong fundamentals of the country as well as its robust growth potential
that indeed attracts voluminous domestic institutional investments leading to surge in the performance of capital market
activities.
4. Conclusion
This paper is an attempt to examine the role of Indian mutual funds in the capital market of the country. We not only
looked at the fundamental growth of the Indian mutual fund industry, but also examined the dynamics of the causal
relationship that runs between the growth of mutual funds investment and capital market development. The study
contributes to the literature the evidence of unidirectional causality running from the movement of stock market returns to
the movement of mutual funds activities in India. Thus, the policy makers in India should take necessary steps to reduce the
volatility of the Indian capital market thereby helping putting the mutual funds industry in a high growth trajectory. The
robustness of this study, however, is delimited by the inter-play of macro -economic factors inflation at home, interest rate
volatility, foreign institutional investments, international crude oil price changes, volatility of forex rate, and transnational
economic and financial contagions. Hence, the scope for further research is to include more variables in this causality
study.

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