Retail flows into equity mutual funds have historically followed a predictable pattern. Flows rise when the markets are doing well, and they fall when the markets are correcting. And in what is a clear reflection of the investment time horizon in this category, the key yardstick that is followed is the past one-year return of equity mutual funds. Whenever one-year returns are poor for successive months, flows dry up and there are even net outflows from equity mutual funds, as was witnessed in early 2014 and 2016.
But the correction in the vast majority of stocks this year has had a different response from retail mutual fund investors. While returns have been negative in a large number of equity funds, flows have remained fairly strong, thanks to the growing popularity of systematic investment plans (SIPs). This has brought the Indian stock market into a realm it has never been to before, and one that is having interesting effects on stock valuations.
Monthly inflows from mutual fund SIPs have more than doubled in the past two years and now stand at ₹ 7,658 crore, or well over a billion dollars. This is despite the correction in the markets this year.
A moot question is if stock prices will get irrational (or more irrational, as some might say) if such large regular flows through the SIP route continue, regardless of market conditions. As a matter of fact, the steadily increasing flows have already impacted stock prices and valuations in strange ways.
According to the head of research at a multinational brokerage, “Domestic fund managers, faced with increasing flows in a market where valuations are already rich, have responded by increasing allocations to so-called quality stocks, resulting in extremely high valuations in a few select stocks."
It is no secret that broad market indices have held firm only because of a rally in a few stocks that have large weights in these indices.
Of course, in some cases such as with Tata Consultancy Services Ltd (TCS), valuations had become so rich that fund managers started looking at alternatives in the sector.
But this brings us to the quandary fund managers and investors are facing. Not all information technology (IT) companies have gained from the shift in client spending towards digital services, although nearly all IT stocks have risen handsomely.
As such, there are a number of cases where stock prices are rising because of increased flows, although there may not be a commensurate increase in earnings growth to justify the increase in valuations. “Asset prices won’t turn wonky if earnings grow at a healthy pace," says the head of research cited earlier.
While we wait for healthy earnings growth to materialize, there is a fair amount of comfort as far as flows into the market are concerned. Even though flows from non-SIP sources into equity mutual funds continue to gyrate, based on market conditions, SIP flows provide hope.
An important feature of SIP flows is that they are far stickier than one-time purchases, and are hence not expected to disappear, unless there is a meltdown, like the one during the 2008 financial crisis
As one industry executive said recently, the catchphrase that comes to mind now is “Mutual fund sahi hain", compared to the earlier “Mutual funds are subject to market risks".
The growth in SIP flows clearly demonstrates this, although ignoring market risks will have its costs that may be visible only later.