Indian mutual funds have pumped about ₹1.2 trillion into the equity markets in each of the last two years

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.

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.

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.

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.

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.

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.

source: livemint.com