HDFC AMC - One Of India's Largest Mutual Fund Houses Appears To Be Overvalued

With assets under management (AUM) of Rs 4 lakh crore, HDFC AMC is one of India’s largest mutual fund houses. Its strong brand, performance and a huge distribution network has propelled it to the top position over the last two decades.

Nevertheless, the stock has underperformed the index over the last two years and one can quite safely argue that the company is currently overvalued.

Here are some structural issues that are affecting HDFC AMC's valuations, growth and performance.

First, in the company of its global peers HDFC AMC does not look very well for multiple reasons. One of the main reasons is flexible revenue models and SEBI imposed fee caps.

HDFC AMC’s market capitalisation is 15 per cent of its AUM. The US-based asset manager, Kolhberg, Kravis Roberts & Co. (KKR), is also valued similarly. However, the monetisation of the AUM is starkly different for HDFC and KKR. Fund managers like KKR can charge one to two per cent of the AUM as investment management fees, irrespective of fund size.

In contrast, fees for mutual funds are capped by SEBI on the basis of fund size. Firms like KKR also have profit-sharing contracts in place with their investors, wherein they receive a share in the profits after they cross a certain return threshold. Therefore, KKR’s AUM is more valuable than HDFC’s AUM.

KKR also has access to sweetened deals and invests its own capital, thus augmenting returns for shareholders. It pays to remember that KKR’s valuation has averaged around four to five per cent of its AUM – the current valuation seems to be an aberration.

Similarly, Charles Schwab is valued at around four per cent of it AUM. The huge discrepancy in valuations is often justified by quoting the Indian financial sector’s growth potential.

Second, the company's operational revenues are growing at a much slower pace compared to its AUM.

Over the last five years, the company’s AUM has grown from Rs 172,598 crore in FY16 to Rs 395,476 crore in FY21, implying a compounded annual growth rate (CAGR) of 18 per cent over five years. These figures are in line with the purported growth story.

Despite the rapid growth in AUM, the AMC’s operational revenue has grown at a CAGR of merely five per cent. For FY21, AUM has grown by around 23 per cent, while revenue has de-grown by six per cent.

To reconcile the vast difference between AUM growth and revenue growth, we must understand that not all AUM is created equal. Assets under management include money invested under debt schemes, equity schemes, and liquid schemes, among other products.

Each scheme has a different Total Expense Ratio (TER). The TER is the percentage of money charged by the mutual fund to cover its expenses. After paying for basic expenses, the remaining money is passed on to the AMC as an investment fee. This investment fee is then recorded on the AMC’s books as revenue.

Debt-oriented schemes have a much lower TER compared to equity-oriented schemes. Therefore, in order to grow revenue and profitability, a fund must grow the equity-oriented AUM. For HDFC AMC, the contribution of equity-oriented schemes towards AUM has remained constant at around 40 per cent for the past five years.

To be fair, AMC has been working on developing its portfolio management services (PMS) and alternative investment funds (AIF) business, but these high-margin businesses still contribute to around two per cent of AUM and have not really moved the needle for the company. Therefore, unless the contribution of higher-margin schemes in the AUM grows, the revenue performance will remain lacklustre despite increasing AUM.

Third, there is now the threat of passive investing on the horizon. Active funds, which generate the highest fees for AMCs, often do not generate the alpha they promise their investors. Alpha is the additional return a fund earns over the index because of the fund manager’s skill. A fund manager is more likely to generate alpha in inefficient and under-researched markets. On the flip side, when the market matures, it is difficult for fund managers to generate alpha.

Since beating the market can be a tough job, many investors turn to passive investing strategies. These funds focus on maximising returns by tracking a fixed basket of assets and minimising portfolio turnover. Since passive funds are commoditised products with low overhead costs, they usually have a lower expense ratio. It is reported that passive funds account for more than 50 per cent of the mutual fund industry’s AUM in the USA.

Passive investing has been on the rise in India. An analysis of AMFI’s data for open-ended equity-oriented schemes showed that passive funds like Index funds and ETFs contributed to around 12 per cent of equity-oriented schemes’ AUM in 2019. In 2021 the figure rose to 19 per cent. As Indian markets mature, it is likely that the inflow into passive funds will continue rising.

Naveen Munot, the managing director and chief executive officer of HDFC AMC, highlighted the issue during the Q1 FY22 conference call – “I think, globally, if we see the way margins have been under pressure in this industry, with the move happening from active to passive and markets become more and more efficient, obviously, there would be some pressure and I think we cannot deny that”. While active investing is here to stay, the proportion of actively managed AUM is likely to decrease in the future.

Fourth, we're now seeing the rise of direct investing. For HDFC AMC, direct plans contributed to around 47 per cent of the AUM in FY21. This number was 32 per cent in December 2017, when the company filed for an IPO. The rise of direct investing indicates a shift from the distributor-led model.

The internet has largely decimated information asymmetry in the mutual fund space, with corporate and institutional clients preferring the direct investment route. With this change, AMCs need to focus on generating more returns for their products rather than relying on distributor incentives and networks to enhance AUM.

When earnings do not justify the valuations, valuations either drop or remain flat until earnings catch up. The latter has been true for HDFC AMC so far.

The AMC has also been losing market share and unique investors in recent quarters. Unless some catalyst boosts the company’s performance, it is unlikely that AMC’s valuations will sustain or improve.