The Indian mutual fund industry has traditionally been faced with an unstable asset composition, a small geographically skewed retail investor base, and a relatively insignificant share of household savings.

A pervasive issue, and one which SEBI is already attempting to combat, is the mutual fund sales and distribution structures and practices.

The prevailing incentive models in non-proprietary intermediation have imposed three serious threats to mutual funds operating in India. The first is the captive market syndrome where commissioned agents depress both AMC margins and investor returns by demanding high front-end charges and trailing commissions.

The second is an escalation in churning practices. The third is distributor disinterest in sales to potential SIP investors. These front-end inefficiencies flow back to AMCs in the form of higher costs, lower profits and erratic investor behaviour.

At one level, this is simply an issue of how the costs involved are shared across the food chain. The customer is unlikely to complain as long as returns on investment match expectations and the actual costs are not transparent. If both product providers and sales and distribution actors are making profits, the only tension is the relative shares each receives.

While economic conditions are buoyant, and general investor savvy is low, these tensions are at worst manageable. However, if general economic conditions sour, or investors demand higher returns, or regulators demand greater transparency in fees and charges, pressure will mount on product providers to lower asset management fees while distributors will seek to make up their losses through escalated charges and/or churning.

With sales incentives skewed heavily towards transactions and investment volumes, it is not surprising that distributors have shown little interest in delivering value added advisory services or in growing the underlying investor base. In this scenario, mutual funds should evaluate alternative sales and distribution arrangements that better protect their long term positions and more effectively insulate them from market fluctuations and tax policy changes.

However, sales and distribution practices are only one of the many reasons for low retail penetration by India's mutual fund sector. Till a few years ago, for example, the incomes of most Indians were at levels too modest for mutual funds to be of active interest. This has rapidly receded into history as India seems set to shoulder its way into a more prosperous future and with average incomes in India rising by nearly 30 per cent from the 2004-05 levels.

Another reason is that smaller retail investors traditionally have been offered a limited range of investment options and most household savings have been channeled into either low yielding bank deposits or to life insurance policies. This has produced what is, for the moment at least, a low risk appetite in the minds of many small investors.

Interest rate subsidies offered by the government as a back door method of selling government paper through various savings schemes offered by India Post have not helped either as they have herded a significant share of household savings in that direction. And finally, the mandatory publicly managed pension and provident funds have consumed over US $50 billion of stable and long-term household savings.

In all of this, the mutual fund industry itself also needs to accept a large part of the responsibility for the inertia as the various mutual fund players are yet to come together to more effectively promote the industry as a whole. As a result, mutual fund investment opportunities have yet to come onto the savings radar of most individuals with incomes in India as nearly 90 percent of them do not know that mutual funds exist. Of those who are aware, over 30 per cent could not recall even a single mutual fund brand. The fact that the mutual fund investor base is small therefore can be pinned substantially to this factor alone.

An important flip side to this analysis is that the existing retail mutual fund investor base represents some 18 per cent of the "aware" population. This suggests that the mutual fund investor base can be grown significantly if visibility levels among the larger audience, where visibility does not exist, is raised. In the mass market context, it is also significant that existing mutual fund investors are heavily influenced by social and familial networks in first being attracted to the mutual fund option.

Hence the underlying size of the investor base can play a key role in attracting new investors. In part, attracting the smaller investor can swing on effectively promoting the systematic investment plan (SIP) approach wherein smaller investors can more easily participate, and in the process spread risks more effectively when doing so. The problem is that the visibility of the SIP investment approach is lower again, with less than half of even the aware population relating to the possibility of investing in this way.

But there are signs that change is in the wind. According to new research posted by IIMS Dataworks, the mutual fund retail investor base is today at 5.3 million. Life insurers also are experiencing good success with selling ULIPs while equity markets are ramping up with over 4.3 million individual investors. Looked at in this way, the base investor mass of interest to mutual funds already stands at over 10 million, as lying at the bottom of all three investment options is the mutual fund industry's stock in trade - a booming securities market.

Importantly, the potential mass market demand for mutual fund type products outside of this population is not a central issue. At a conservative estimate, an additional 34 million individuals, with the capacity and interest to invest up to US $14 billion annually in mutual fund type products already exists in India. However, over 57 per cent (19.6 million) of this population lives in rural areas.

Therefore, while most of the new demand from existing mutual fund investors will naturally come from middle and higher income earners, most of the potential mass market for mutual funds is likely to be found mainly among the lower and lower middle income groups.

For obvious reasons, this population is unlikely to be of much interest to the existing sales and distribution channels for mutual funds. Most of these potential investors (78 per cent) can instead be reached through the banking and postal networks. On the ground, promotional activities by the mutual fund industry at a bank or postal branch level also may reap rich dividends as three in four of these customers usually visit their bank at least once a month.

In money terms, retail investment flow in mutual funds in the last 12 months stood at US $5.6 billion. Importantly, this result has been achieved with a mutual fund penetration of the active workforce of less than 2 per cent. If the mutual fund industry manages to mobilise the necessary effort to bring the huge number of potential investors for whom mutual fund investments are not yet on the radar, the sky could literally be the limit.

Gautam Bhardwaj is director of Invest India Economic Foundation. This analysis is based on the Invest India Incomes and Savings Survey 2007 produced by IIMS Dataworks.