With the notification of the Securities and Exchange Board of India (SEBI) (Mutual Funds) Regulations, 1993, the asset management business under the private sector took its root. At present, there are 28 mutual funds in India offering different schemes tailored to meet investors' growth, safety and income requirements.

Over the years, the total assets under management have multiplied with much of that growth in the last two years. These constitute approximately 6% of India's gross domestic product (GDP). The total assets under management as at August 2004 amount to Rupees 1,558 billion. The industry looks poised for more growth as increasingly market-savvy investors seek better returns in a low interest rate economy.

Foreign capital is flowing into the country at an enormous pace. Participation of foreign institutional investors (FIIs) in the Indian economy saw significant fluctuations during the period April 2004 to August 2004. The boom in the primary market gave impetus to FII investment in India, though there was a significant downfall during April 2004 and May 2004 on account of political uncertainties and unexpected change in power at the Centre.

In its draft report to the Ministry of Finance, Cadogan Financial, a UK-based company which is a specialist in development of collective funds worldwide, has commented that the Indian asset management industry has grown at a rate slightly faster than the UK but slower than the US. India has scored over the UK in areas such as information systems, transfer agency and performance analysis.

The report has also highlighted some imperfections that plague the investment management industry in India. Some of these are as follows:

• Investments in mutual funds are for a very short term and are mostly by corporate houses;
  
• Preference of retail investors towards high-return low-risk products like National Savings Schemes and government guaranteed schemes; and
  
• Lack of incentives to distributors to target the retail market.

Some of the recommendations given in the report to enhance the growth of the investment management industry in India are as follows:

• Development of a better regulatory framework for mutual funds;
  
• Removing limits for investments in overseas securities by mutual funds;
  
• Improving timeliness and cost efficiency of money transfer in rural areas; and
  
• Developing a specialist fraud unit in order to tackle financial crime.

The investment management industry in India is expected to grow at an even faster pace if problems identified by the Ministry of Finance report are appropriately addressed.

Tax Reforms

In his interim budget for the fiscal year 2004-2005, the newly elected Finance Minister of India, P. Chidambaram articulated his vision of making India an attractive destination for investment. He has acknowledged the positive role played by FIIs by announcing measures to simplify their entry process and allowing them a larger access to the debt market. The changes and reforms proposed by him are to:

• Raise the investment ceiling for FIIs in debt funds from US$1 billion to US$1.75 billion;
  
• Allow banks with strong risk management systems greater latitude in their exposure to the capital markets; and
  
• Examine and implement the recommendations pertaining to the liberalisation of FII limits in certain specified sectors so that genuine FIIs which are professional bodies of asset managers and financial analysts can enhance the flow of equity capital and lend depth to the capital markets.

An endeavour has been made to simplify the tax regime on financial market transactions. Securities Transaction Tax (STT) has been introduced and long-term capital gains tax has been done away with. Tax rate on short-term capital gains has been reduced to 10%.

Apart from the above, the following changes have been proposed which directly affect the investment management industry in India:

• Dividend distribution tax on income distributed by debt-oriented mutual funds to individuals and Hindu Undivided Families (HUFs) is to be charged at the rate of 12.5% and at the rate of 20% for other investors. Earlier, the rate was 12.5% for all investors;
  
• Income distributions made by equity-oriented mutual funds continue to be exempt from tax.

Income earned by a mutual fund is exempt under Section 10(23D) of the Income Tax Act, 1961 of India.

New Trends

Different types of schemes that are already popular in western markets are fast being recognised in India too. Some of these schemes are discussed below.

1. Commodity-linked schemes

This concept has been introduced for the first time in Indian markets. One of the private players in the Indian mutual fund industry has already applied for an open-ended gold fund. If the gold fund succeeds, asset management companies (AMCs) may float other commodity-linked schemes.

2. Fund of Funds

Fund of Funds (FoFs) is essentially a mutual fund that invests in other mutual funds. Although, FoFs have been around in the European and American markets for some years, these have arrived in India only in the last two years. Potential escalation of costs and loss of returns on account of portfolio rebalancing are the core problems of these FoFs.

3. Equity Arbitrage Funds or Hedge Funds

The stock market regulator in India, Securities & Exchange Board of India (SEBI) is ambivalent on the issue of acceptance of hedge funds into the Indian Financial Market. However, worldwide trends show that hedge funds are an important force to be reckoned with. Around 40% to 50% of the overseas money flowing into the Indian market is from hedge funds through participatory notes (PN) or offshore derivative instruments that are issued by FIIs against underlying Indian securities. On account of limited convertibility, offshore hedge funds have yet to offer their products to Indian investors within India. However, recently the Reserve Bank of India has allowed resident individual investors to remit up to US$25,000 per year current or capital account transactions which will allow Indian individual investors to explore the possibility of investing in offshore financial products.

4. Real Estate Mutual Funds or Real Estate Investment Trusts (REITs)

The concept is expected to take off shortly once the Association of Mutual Funds of India (AMFI) gets the go-ahead from SEBI, and announces the norms.

India's foray into REITs is very late as compared to America, where these have been in existence since 1960. However, when viewed from the Asian perspective, the region witnessed the emergence of REITs just a couple of years ago. India, the fourth largest economy in the world, has been maintaining a GDP growth rate of around 5.5% for more than a decade with a potential to almost double her present rate of growth with labour and capital productivity improvements. Real estate and infrastructure play an essential supportive role in improving labour and capital productivity. Real estate investment is also a leading indicator of economic growth in all market economies.

Two major steps have been taken by the Indian government to act as a catalyst to the real estate sector — firstly, allowing following direct investment and secondly, setting up of REITs.

5. Pension Funds

Management of pension funds is expected to offer new opportunities of business expansion for asset management companies in India. Globally, mutual funds are managing money for pension funds to help them improve yields by allowing access to a wider range of investment avenues. In the Indian context also, mutual funds can similarly help provident and pension funds.

Major fund houses are awaiting final guidelines for entry into the lucrative pension business that is expected to grow to approximately Rupees 500 billion by the year 2010.

In the near future, these alternative and diverse investment pools are expected to be a source of additional liquidity to the Indian markets.