In today’s Finshots, we dive into Zerodha’s mutual fund ambitions.

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The Story

In 2021, Zerodha* announced that it wanted to set up a mutual fund company. And the plan was clear from the start — they’d launch passively managed funds or index funds.

For the uninitiated, index funds don’t have a fund manager at the helm to pick good stocks and dump bad ones. There’s no one in the background burning the midnight oil to dive into a company's financial statement. They simply buy and hold stocks in the same proportion as an index dictates. This could be the Sensex 30 or the Nifty 500 or something else. If a stock drops out of the index, they’ll sell too. They copy, they mimic, and they mirror the index. That’s it.

And now, we know what Zerodha’s entering the stadium with. Two index funds. One of them is an ELSS (Equity Linked Savings Scheme) - a fund that qualifies for tax savings under Section 80C. And both will track the Nifty LargeMidcap 250 index. So you’re basically getting the biggest 100 companies in India. And then 150 mid-sized companies too. It’ll be an equal split of 50:50.

But why is Zerodha focusing on this index, you ask?

Now we know that the easy thing to do would’ve been to start with an index fund that tracks large companies. After all, that’s the category where active fund management has fallen by the wayside. For instance, over a 5 year period, nearly 94% of actively managed large-cap funds have underperformed their benchmark. But there are quite a few index funds in this category already. Maybe Zerodha wanted to be different. At least during the launch.

And if you take the ELSS category of funds as a proxy for a multi-cap strategy. Then you’ll see a similar outcome — nearly 95% of these funds failed to beat the benchmark over a 5-year period. So this multicap bucket seems like a good place to disrupt with passive funds.

Also, the conviction could come from the fact that the index gives you exposure to 87% of the equity universe listed on the NSE. You’re basically covering the most “important’ stocks that are out there. Sure, you could argue that having 250 stocks is way too much diversification. That it’ll dilute returns. But over multiple time periods, the Nifty LargeMid 250 Index has delivered higher returns than the Nifty 100 Index which just has large companies.

And at the end of the day, investors want just one thing — returns. If you tell them that active fund managers are messing up and give them an index fund option in this category, who knows, they might well make the shift.

Especially since there’s really no competition here. There’s really only one fund from Edelweiss that tracks the same index. And this has garnered a measly ₹60 crores since it launched a couple of years ago.

So Zerodha has a wide and open field. That is if it can convince people about the opportunity to invest in this index.

But there’s still one burning question — what about the money? How will Zerodha rake in the dough?

Well, let’s look at the travails of the mutual fund industry first.

A year ago, we wrote about why the shares of listed mutual fund companies weren’t living up to the hype. See, everyone expected them to do well because of the common refrain — “Underpenetration”. Because as a percentage of GDP, equity mutual fund assets in India were only at 5%. While peers like South Africa were at 27% and Brazil at 18%. However, investors seemed to be a little concerned. These mutual fund companies weren’t able to improve their top/bottom line as expected. In other words, you could argue that they haven’t been able to command a higher fee from their customers.

And if you’re wondering why that was the case, there are probably two things here.

  1. SEBI, the capital market regulator, had started clamping down on the fees that mutual funds could charge. More the money they managed, lower the fees — that was the mantra. That would have an adverse impact on the financial growth of these mutual fund companies. Meanwhile, their fixed costs remained high because most legacy companies had built massive teams with high salaries.
  2. Passive funds were slowly beginning to rise and take away market share from active funds. It’s still nascent but they make up 10% of the overall equity mutual fund pie right now. And by now you know that the fees that these index funds can charge are abysmally low. There’s no fund manager to pay. And the newer set of investors who’re dipping their toes in mutual funds have all the information they want at their fingertips. They know that paying a 1% fee to an active fund manager, who may or may not beat a benchmark, may simply eat away a good portion of their gains. So they’ll increasingly prefer to go the passive route.

Now Zerodha won’t have to deal with the first problem. They’re just setting things up. And they’re actually doing this as a joint venture with smallcase, a tech platform that allows investors to pick baskets of stocks. And with index funds, they won’t need a massive team of fund managers either. It’s mostly tech. Nor will they really have to deal with paying commissions to ‘intermediaries’. You know, the third-party distributors who get a cut of the fee as well. And that’s because Zerodha has already built its own distribution over the past decade. It’s a direct-to-consumer company. So it’s about tapping into this existing network.

But going the passive route does mean that there isn’t too much money on offer either. Passive funds are a commoditized play. The only differentiator is the kind of index you track. And then when competition heats up, it’s a race to the bottom for fees.

Sure, you could argue that Zerodha disrupted the broking industry with extremely low charges. But that’s because they realized that most of the revenues come from active traders and the futures & options (F&O) segment. That was the real money spinner. So they could still do quite well without brokerage from a small subset of investors.

But with mutual funds, there isn’t an alternative. There isn’t a more lucrative side bet. The only bet here is scale — that Zerodha’s existing distribution can help build a large asset base. And that more Indians will embrace mutual fund investing and index funds. Just like they did in the US —a third of BlackRock’s $18 billion fee now comes from these index funds.

So yeah, even a tiny fee on a large asset base can be quite gargantuan. That’s what Zerodha will be hoping for. And we’ll have to wait and see if it really pans out this way.

Until then…

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*Zerodha, through its Rainmatter Fund, is an investor in Finshots.

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