The dangers of high mutual fund inflows
Indian mutual funds have pumped about ₹1.2 trillion into the equity markets in each of the last two years
Mumbai: Nothing sedates rationality like large doses of effortless money,” Warren Buffett wrote in his letter to Berkshire Hathaway shareholders in 2000.
Whether it’s effortless or not can be debated, but Indian mutual funds have been certainly receiving large doses of money in their equity funds. As a result, they have pumped in about ₹1.2 trillion ($17 billion) in each of the last two calendar years into the equity markets. While this has been generally hailed, since domestic institutions are finally a strong counterbalancing force against volatile foreign flows, there are some counterproductive effects to worry about as well.
For one, domestic funds seem to be providing exits to foreign institutional investors at what are generally considered rich valuations. In September and October, for instance, when foreign institutional investors sold equities worth ₹37,250 crore, mutual funds provided the backstop with net purchases worth ₹35,700 crore. Investors had multiple things to worry about during that period, chief among which was the US Federal Reserve’s refusal to pause its rate tightening cycle despite signs of a slowdown. India had its own set of worries, led by the liquidity crisis that erupted in mid-September.
Rationality demanded some selling, which foreign investors did. Similarly, in mid-December, mutual funds responded to the news of shock losses for the ruling party in state elections and the central bank governor’s exit with purchases worth ₹2,700 crore in two trading sessions, at a time when foreign investors were busy selling equities worth ₹4,400 crore.
Perhaps, as Buffett put it, domestic mutual funds were sedated by the large doses of money they were receiving.
Equity mutual funds now receive around ₹8,000 crore monthly through a steady stream called systematic investment plans (SIPs). It works out to nearly ₹1 trillion a year.
“In a sense, this is like a pyramid scheme or a game of musical chairs,” says Sanjay Bakshi, finance professor at Management Development Institute, Gurgaon. “The weight of the money coming in is causing a rise in asset prices, which in turn is drawing more flows that then chase the same assets. History shows that this seemingly endless cycle will reverse one day; and when the tide turns, there will be a quick transition from euphoria to hysteria.”
The problem of plenty, in terms of flows, is exacerbated by a problem of scarcity as far as quality stocks go. It’s the classic “too much money chasing too few goods” problem.
Venkatesh Panchapagesan, associate professor of finance at IIM Bangalore, says: “The limited universe of investible stocks for institutions is a problem, and the fact that the markets regulator isn’t doing anything to broaden the universe just makes things worse. So we end up with a situation where mutual funds are forced to buy stocks that they already own.”
He and his students found that more than two-thirds of new money for top equity funds of two large fund houses went into their existing stocks. The study was over a two-year period from 2016-17. Panchapagesan is on the same page as Bakshi when he says, “It is a vicious cycle of flows driving prices, which, in turn, brings in more flows.”
Are mutual fund SIPs the new dumb money?
Retail flows are generally known as dumb money that provides exits to the smart money of institutional investors. They tend to peak along with market peaks. The narrative earlier suggests the dumb money of this cycle is coming through the SIP route.
Unsurprisingly, there is considerable pushback from mutuals funds about this suggestion. “One cannot time the market,” says Sankaran Naren, chief investment officer at ICICI Prudential Asset Management Co. Ltd. “Currently, we believe the market is neither cheap nor expensive. It is fairly valued. However, there are pockets wherein certain names have corrected sharply over the last few months. Therefore, we believe 2019 is about selective stock picking, rather than benchmark indices.”
The point about timing the market is pertinent. Monthly investments through SIPs follow the recommended cost-averaging investment strategy, where an investor ends up buying more shares when prices are low and fewer when prices are high. This is far better than earlier stock market rallies that would draw one-off investments by retail investors at peak valuations, only to leave them with burnt fingers.
Even with mutual fund SIPs, returns have been poor in the past year, and at least some investment managers are worried retail investors will get disenchanted if equity returns continue to lag other classes such as debt.
As things stand, their belief in equity investments has been resolute. Net inflows into equity funds have remained high in the past four months, despite volatile markets. And debt mutual funds have continued to report net outflows despite far better returns in recent months. In short, it seems to be all equity for mutual fund investors.
“True, there is a perception in the minds of investors that mutual funds are all about equities, which needs to change. And our fund house has been advocating investors to opt for debt funds, balanced advantage/dynamic asset allocation schemes, in addition to equity schemes,” says Naren.
Evidently, the efforts aren’t enough. The SIP phenomenon has gained such a momentum that equity funds are no longer the “push” product they used to be. While in the past mutual fund companies resorted to all sorts of tricks to push sales, such as new fund offerings, even though similar funds already existed, they are now getting large flows despite various curbs by the regulator.
Are fund managers turning cautious?
If flows have stayed high regardless of where valuations are, are fund managers preparing for a soft landing by increasing cash holdings or buying protection using derivatives? For Indian equity fund managers, this is a strange sound.
“A fund manager has to assume investors have made their asset allocation decisions and want us to manage their equity exposure. If an investor has allocated only a small proportion to equity and finds that we are dithering from taking equity exposure in our equity funds, it doesn’t serve his purpose,” says a fund manager. So, it isn’t surprising that all equity funds put together have kept cash levels at between 4-5% of assets in the past six months, according to data from Value Research.
There have been attempts to launch products that make the asset allocation decision depending on market conditions, such as the Balanced Advantage Fund pioneered by ICICI Prudential, but investors have preferred to stick to pure equity products. For retail investors, 72.6% of their MF holdings worth ₹5.65 trillion were in equity-oriented products in end-September, with another 11.5% in balanced funds. This brings us back to the weight of money argument Bakshi spoke of. “The weight of money argument, like any other that supports high asset prices, is a fragile one. What now looks like a virtuous cycle can turn vicious if the trend turns from inflows to redemptions,” he says.
Of course, it’s anybody’s guess when the tide might turn. Buffett likens this to Cinderella at the ball. “They (market participants) know that overstaying the festivities—that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future—will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: they are dancing in a room in which the clocks have no hands.”
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