Limits are good, if they are managed well
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In December 2017, two different equity mutual fund schemes, investing in mid- and small-cap stocks, almost simultaneously restricted daily inflows, citing limited investment opportunities at current prices. Their decision to do so received validation in January 2018 with another asset manager deciding to return investor money from two small cap-oriented schemes (these were portfolio management schemes).
Given that both the mid- and small-cap indices have corrected slightly over 10% since the end of January 2018, shows that there was merit in the analysis that valuations in these segments had run too far ahead.
But what does restricting inflows achieve? Aren’t open-ended schemes designed to take in money at all times, regardless of market conditions and quantum? Moreover, aren’t regular inflows the business case for an asset manager to survive? Restricting inflows was an attempt to stick to fund mandate and safeguard existing investors from potentially diluted returns.
Mutual fund schemes cater to investor demand in a particular market segment; in this case, mid- and small-cap stocks. This segment is synonymous with high-risk high-return investing. The high returns are potentially generated by investing in good-quality, relatively lesser-known, under-researched companies that gain market capitalisation as earnings grow at an exponential pace.
But why take the high risk? With the operational risk of scaling-up earnings, there is liquidity risk too. Low market capitalisation and fewer shares for public investment make these shares illiquid. So, a large buy or sell order for the stock can significantly affect its price.
The benefit of restricting inflows
As fund size grows, it may not be rewarding to allocate more (without impacting market price) to the same stock. Fund managers are forced to look for other stock ideas. If markets continue to rally, these are harder to find at a reasonable price. The choice then is to look beyond and buy the more liquid large-caps. Returns then start to get diluted from those painstakingly gained through mid- and small-cap alpha ideas.
In comes the solution of restricting flows. Limits are used in various fields to instil discipline towards a more accurate outcome: sports persons have dietary limits, car speeds are limited within city limits, even cash-backs on debit cards are limited. But restricting inflows into an open-ended equity scheme is not that kind of a limit.
A behind-the-scenes look at the monthly inflows of a scheme that has restricted inflows, shows that inflows have risen each month despite the limits. A year later, the monthly sales had increased 2.9 times that of the first month after the limit was introduced. Hence, asset growth came at a more stable stride. But does that really aid performance?
IDFC Premier Equity Fund, a pioneer in this strategy, was the only one that restricted inflows for several years. The performance of the fund remained top quartile for many years (with a change in fund management, the profile of the scheme too seems altered now) and the steady pace of inflows through systematic investment plans (SIPs) was found to be a more balanced way to scale up.
If we look at the ranking of three funds that restricted inflows in 2015 and 2016, two have retained their peer group ranking for 3-year performance (as given by Valueresearch online) in 2017 as compared to 2016, and one fund has slipped. One may argue that there are other funds in the mid-cap category that are much larger and haven’t restricted inflows. The largest in the category is a Rs20,000-crore fund. A quick check of returns in 2017 will show serious underperformance when you compare returns of large sized mid-cap funds with some of their smaller competitors, although linking performance directly to size is looking at an incomplete picture.
A senior executive from a mid-sized AMC pointed out that “…a large-sized, well-established mutual fund brand can afford to keep taking inflows at the cost of performance; for us it’s not an option. If performance drops, our inflows will suffer….” The problem lies in getting too much money too soon, in a market where investment opportunities at a reasonable price are limited. The pace of inflows matters. For most of the schemes that decided to limit inflows, assets under management increased two to three times in a matter of 5-7 months.
This brings to fore the root cause—lack of depth in the domestic equity market. While the largest listed stock has a market capitalisation of Rs6 trillion, by the time you get to the 251st stock (under the new categorisation guidelines it is now a defined small-cap stock) market capitalisation has fallen to Rs95 billion. Liquidity in this segment is a big issue. Moreover, the inflows of Rs1.3 trillion into equity mutual funds were higher than the Rs740 billion collected through initial public offering in 2017; thus, mutual fund inflows are outpacing new stock listings.
End note: Why is there such fast-paced growth in assets for mid- and small-cap equity funds? Many new investors are shifting to mutual funds from other physical and financial investment avenues. Ideally, they should be careful about investing too much in these funds. Even so, it is seen that many new PAN numbers are getting registered for KYC here. It’s almost like giving 5-year-old children an iPad and expecting them to understand the consequences of its overuse. First-time equity investors may not be mature enough to understand the risks in mid- and small-cap stocks. Their steps need to begin with steady, consistent-return options via large-cap funds or hybrid options like balanced funds.
Lisa Pallavi Barbora is a consultant with Mint