Zerodha’s Nithin Kamath: It has been a painful bull market for active traders

Year after year, Zerodha springs up a surprise with its annual financial filings. In a startup ecosystem, laden with sky-high valuations and distant dreams of profitability, the Bengaluru-based fintech platform is an island.

In FY22, the company recorded an almost two-fold jump in net profit to Rs 2,094 crore while revenue surged 80 percent to Rs 4,963 crore. However, founder and CEO Nithin Kamath cautioned yet again that stockbroking is a cyclical business that fares only as well as the markets. New investors flock to the equity market when it rises. And, they desert brokers when the going gets tough.

Kamath says that hints of a deep trough of this cycle are already visible. While new customer additions to the platform peaked around 350,000 a month in late 2021 and early 2022, the metric has been downhill ever since.

Yet, the company expects to repeat, and perhaps better its FY22 feat in FY23 even as the financial year draws to an end.

However, he believes that it will be hard to keep up with those numbers this year. This means that FY24 could take a hit for the online broker which processes around 6-7 million trades on an average day, on behalf of its 12 million user base.

Kamath, who has often described himself as a bear, is also an investor in early- stage fintech startups. He believes that the worst of the funding winter is yet to come. Down rounds will happen, as will a lot of mergers and acquisitions. “But I think we're at least six months away from that,” he says.

In a chat with Moneycontrol, Kamath talks about Zerodha’s plans for the future, how passive mutual funds have remained under-sold due to the conflict of interest of asset management companies, the probable return of fixed deposits as an investment option, and more.

Edited excerpts:

Q: We are just a quarter away from completing FY23. How has this financial year been?

A: We are on track to do almost similar numbers in terms of profitability and revenue, maybe 5-10 percent more. But we are already seeing our growth plateau over the last three months. With the markets now coming down slightly, it's only going to get worse from here. I don't think we will be able to repeat that performance in FY24.

It also seems we have, at least temporarily, hit a dead end in the target market itself. You know how many people out there who can potentially trade, invest, etc.

Q: Is the performance of your direct mutual-fund platform Coin also included in the Zerodha numbers?

A: Yeah. This is the broking entity, so everything comes under this, but Coin doesn't really generate any revenue for us directly. There’s an indirect revenue in terms of an annual maintenance charge of around Rs 300 that we earn on the demat account. But, that too, can be charged only for active users.

Q: You also have an account opening fee of Rs 200. Given the large revenue and profits you have, these charges would be a small fraction of the business. Some of your competitors don’t charge these fees. What prevents you from doing the same and attracting more users? 

A: About 70-75 percent of our revenue comes from active traders who pay us Rs 20 per trade, although we don't charge any brokerage for equity investing. This means you can invest in stocks, hold it for one day and sell it and not pay us any money. All other charges, including account opening and maintenance, would constitute around 7 percent of the revenue.

We have always thought about these things in a counter-intuitive manner. See, the account opening charge for us is to sense the seriousness of the user as every new account means more overheads in terms of tech, risk compliance, support burden. Our theory has been that, by charging account opening fees, we only open accounts for people who are serious about trading.

Someone who wants to just see the platform won't open an account with us and then burden us. If you give free stuff, everyone will take it, but what's the point?

Q: So, it doesn’t matter if competitors are adding new customers?

A: We are not trying to sugar-coat user numbers, right? We would rather have serious users. The other thing in any regulated financial service business is that you might end up being looked upon as a concentration risk if you capture too much of the market share. We would have 14-15 percent of the market at this point. So, we're happy our competitors are growing.

Q: Coin has become quite large with assets under management of Rs 33,000 crore. What’s your plan to monetise the platform in the long term?

A: In July last year, there was a Sebi circular that users have to move money separately to buy stocks and mutual funds. Earlier, they could use the money in their trading accounts to buy MFs. So, that has ruined customer experience on Coin a little bit.

On Coin, what we're saying is people who come to Coin already know what funds they are trying to buy. We want to make that as simple and easy as possible. Eventually, the longer term plan is that we have to figure out a way to build an advisory business -- either directly or partnering with a startup-- and Coin will play the role of a foundational block.

If you're gonna advise customers, mutual funds will probably be the most significant portion of the portfolio.

Q: MF inflows have remained strong despite markets being choppy. Meanwhile, you have also received a regulatory go-ahead to operate an asset management company.

A: We are still awaiting final approvals. Whenever that comes, we can perhaps launch the business in three months. We have still not finalised what should be our first product, but the plan is to offer passive mutual funds.

Q: There are already many passive mutual funds in the market. Why do you think you can do better?

A: I think today there are no AMCs in the country which are only into passive MFs. I think the first thing that can be done better is to be a thought leader in passive products. Today, every AMC sells both active and passive funds. And they tend to make more money from selling active products. They are very conflicted themselves.

If you have two products and one earns you 10 times more, why would you sell the one that earns 1/10th? I think people who buy passive products in India are people who are self-aware, and who are handling their own money. Nobody is actively creating awareness about passive products.

Q: So, you aspire to become like the index fund giant Vanguard?

A: Yeah, but not even that because Vanguard is just like a moonshot. I'm saying you need someone to come and talk about passive mutual funds, right? I mean you need to create awareness about passive funds. While there is a little bit happening here and there today, it's not a lot.

The second thing about passive MFs is that your need to have large teams and chief investment officers reduces significantly. So, you can potentially run a passive-only AMC at a lower cost than an AMC, which does passive-plus active.

The third thing is that you can leverage technology a lot more, with operational and compliance risks coming down a lot. For instance, there won’t be any front-running possible in a passive-only AMC. But, it is also going to be a very commoditized product because your scheme can’t be your moat. Anyone can launch it as it is linked to an index. The moat will have to be how you run the AMC operationally and the thought leadership of running a passive-only fund.

Q: The lowest management fees passive funds charge today is around 0.15 percent. Do you think there’s scope to go even lower?

A: I don’t think India has the scale for that to go down. Even if you get to Rs 1 lakh crore in AUM, you will only make Rs 150 crore in revenue at the rate of 15 basis points. And getting to Rs 1 lakh crore in AUM is really, really hard in India.

So, I doubt if the fees can go lower at the current scale of the market in India. I am not entirely sure what the revenue opportunity is going to be, but I think it will take a long time for this business to generate serious revenue.

Q: Nifty50 and Sensex have grown around 15 percent and 15.5 percent in CAGR terms, respectively, over the last 20 years. For someone starting his/her investment journey today, how do you tell them it is a good idea to invest in index funds for the next two or three decades?

A: I think it is a no-brainer. Firstly, there’s a huge delta in terms of the fund management fees where you are already paying 1/10th for a passive fund. So, your returns are already one percentage higher every year. Now, the other thing is as the world has gone digital and the information asymmetry has reduced, it has become very hard for active fund managers to beat the index, not just in India but across the world.

There are only a few outliers who do it.

In the small-cap and mid-cap space, some fund managers can potentially end up picking mega winners that can help them beat the mid-cap index. I think, in the large-cap space, it's a no-brainer to just invest in index funds. Why not just go by the broader index, which is anyways very well diversified? It does a good job in terms of risk management of the portfolio, and there is also no risk of fund management.

Q: You have also got the green light to operate a National Pension Scheme fund. What is going to be the strategy there?

A: I think we should be able to go live in the next 2-3 weeks. The good thing about the NPS is that it is locked in. Everyone needs a retirement plan. The issue with your normal investments is that if you are triggered by emotions, you can go buy something or take a loan against it.

With NPS, there's nothing we can do, apart from just being a platform to distribute NPS. I mean the only thing I think people like us can do is create awareness about NPS. That's about it.

Q: Talking about pension funds, VC fund managers are of the view that one of the factors that led to the growth of the American tech ecosystem was investment by large pension funds. Some of them have asked for the EPFO to be allowed to invest in VC funds that back tech startups. What’s your take on the matter?

A: I think wealth creation has to happen within the country. In the last 13-14 years, one of the problems is that the wealth has gotten created outside India. If we, as a country, have to do well in the long run, we need the money to be within India, that money paying Indian taxes, and getting distributed within India in some way.

That won't happen if a VC sitting in the Valley is investing in an Indian company and makes money.

I think wherever there is an opportunity, the government should help Indian startups in whatever way possible, be it (EPFO) directly investing in startups or through VCs. I think it is needed now because we need to remove the dependency on foreign capital to determine where our markets go.

Q: What about the risk?

A: Everything in life is about a risk-to-reward ratio. If you are taking on a higher risk, you have to risk a little amount of money. If EPFO is taking a 10 percent exposure to Indian equity markets, the exposure to private markets would probably be limited to half a percentage point. You have to adjust your allocation based on the risk at the table.

I think we shouldn't let go of the opportunity as India is poised to become an economic superpower over the next 25 years. We don't want all that wealth to have gotten created outside. I think we should take the risk, you know. It's worth taking the risk.

Q: Fixed deposits have lost attraction as an investment instrument over the years. Falling interest rates on deposits have compelled people to move towards stocks and MFs. With interest rates rising, do you think they could make a comeback?

A: Fixed deposit rates are determined by market forces. Now, can you artificially give higher fixed deposit rates just because someone is a senior citizen, etc? I don't think that should be done.

For sure, fixed deposit rates being lower has been the reason why so many people have gravitated towards equities and mutual funds. It’s not just an India phenomenon. Now that the Fed rate has gone above 4 percent, a lot of my friends in the US are like, ‘Dude, why even take the risk in stocks?’. They would rather keep the money in a fixed-income product.

Also, I think while it seems that the markets are not going anywhere, we are just 4-5 percent away from all-time highs. Usually, MF inflows tend to slow down when the market is 10-15 percent below all-time highs. That's when people ask: ‘Dude, I'm losing some money, should I continue investing more or not?’ We will have to see what happens at that point.

Q: Where do you think the Indian markets are heading?

A: It’s extraordinary how well our markets have held up while more developed markets have been bleeding. The primary rule in the market is: don't ever go against the trend. If something is showing it's very strong, I think you have to take a bet that it will continue to remain strong. I know there are a lot of people who are all thinking the market will fall. As such, this actually has been a very painful bull market for a lot of very active traders. When the US market is bleeding, I'm sure a lot of people would have exited, thinking we will also fall.

There is no one right answer to this but if I were to bet, I would say we will continue to remain strong, as compared to the other markets, 60 percent, and we might fall in the next one year, 40 percent.

Q: However, the private market valuations of startups have already seen huge corrections. And fintechs have been hit hard. You are also an investor in fintech startups. What are you seeing?

A: When we make fintech investments, our focus is only around savings, investing, etc. We haven't invested in any of the NBFC plays or those that focus on lending. A majority of the fintech players out there are in the lending space. So, our interactions are very limited in the overall fintech space.

I think Indian startups got very lucky as they raised a lot of money before this whole collapse happened last year. So, many of these companies are flush with funds. I think the pain will start kicking in somewhere towards the end of this year when they have to raise again. There will be down rounds and M&As. But I think we're at least six months away from that.