Risks of High Mutual Fund Inflows

Whether this is spontaneous or not can be debated, but Indian mutual funds are definitely getting a sizeable amount of money in their equity funds. As a result, they have pumped almost 1.2 trillion ($17 billion) in each of the last two calendar years in the equity markets. While this has been generally praised, as domestic institutions are ultimately a strong counterbalancing force against volatile foreign inflows, there are few counterproductive effects to worry about as well.

For one, domestic funds offer foreign institutional investors the flexibility to exit in the form of generally rich valuations. In September and October, for example, when foreign institutional investors sold equity 37,250 crore, mutual funds provided the backstop with net purchases of Rs 35,700 crore. Investors had many things to worry about during that period, chief among which was the US Federal Reserve’s refusal to halt its rate hardening cycle despite signs of a recession. India had its own concerns due to the liquidity crisis that emerged in mid-September.

Rationalization demanded some selling, which foreign investors did. Similarly, in mid-December, mutual funds reacted to news of a shock loss for the ruling party in state elections and the exit of the central bank governor. 2,700 crore in two trading sessions, at a time when foreign investors were busy selling equities worth Rs 4,400 crore.

Perhaps, as Buffett put it, domestic mutual funds were deluded by the large doses of money they were receiving.

Equity mutual funds now receive approx. 8,000 crore monthly through a steady flow called Systematic Investment Plan (SIP). it almost works 1 trillion a year.

“In a sense, it’s like a pyramid scheme or a game of musical chairs,” says Sanjay Bakshi, finance professor at Management Development Institute, Gurgaon. The turn is drawing more flow which then chases the same asset. History shows that this seemingly endless cycle will one day be reversed; And when the tide turns, there will be a quick transition from euphoria to hysteria.”

In the case of flows, the problem of abundance is exacerbated by the problem of scarcity as far as quality stocks are concerned. It’s the classic “too much money chasing too few stuff” problem.

Venkatesh Panchpagesan, associate professor of finance at IIM Bangalore, says: “The limited universe of investable stocks for institutions is a problem, and the fact that the market regulator is doing nothing to broaden the universe is just making things worse.” makes it worse. So we end up with a situation where mutual funds are forced to buy shares that they already own.”

He and his students found that more than two-thirds of new money for the top equity funds of the two big fund houses went into their existing holdings. The study was conducted over a period of two years from 2016-17. Panchpageesan echoes Bakshi when he says, “It’s a vicious cycle of inflows driving up prices, which, in turn, bring about more inflows.”

Is Mutual Fund SIP the new waste money?

Retail inflows are commonly referred to as silent money which provides an exit to the smart money of institutional investors. They tend to peak with market peaks. The earlier narrative suggests that this cycle’s idle money is coming through the SIP route.

Unsurprisingly, there has been a lot of backlash from mutual funds about this suggestion. Sankaran Naren, chief investment officer, ICICI Prudential Asset Management Co. Ltd., says, “The markets cannot be timed. There has been rapid improvement in the last few months. Hence, we believe 2019 is about selective stock picking rather than benchmark indices.”

The point about timing the market is relevant. Monthly investments through SIPs follow the recommended cost-averaging investment strategy, where investors buy more shares when prices are low and less when prices are high. This is far better than earlier stock market rallies, which would attract lump sum investments by retail investors at extreme valuations, only to leave them with burnt fingers.

Even with mutual fund SIPs, returns have been poor over the past year, and at least some investment managers worry that retail investors will be disappointed if equity returns lag behind other segments such as debt.

As things stand, his belief in equity investing has remained firm. Net inflows into equity funds have been high in the last four months despite volatile markets. And debt mutual funds continue to report net outflows despite better returns in recent months. In short, it appears to be all equity for mutual fund investors.

“True, there is a perception in the minds of investors that mutual funds are all about equity, which needs to change. And our fund house has been advising investors to go for debt funds, Balanced Advantage/Dynamic Asset Allocation schemes apart from equity schemes.”

Obviously, efforts are not enough. The SIP phenomenon has gained such momentum that equity funds are no longer the “push” products that they used to be. Whereas in the past mutual fund companies used all kinds of gimmicks to increase sales, such as offering new funds, even if they were similar. Funds were already in place, now they are getting huge inflows despite various restrictions by the regulator.

Are fund managers getting cautious?

If inflows remain high, irrespective of valuations, are fund managers preparing for a soft landing by increasing cash holdings or buying a security using derivatives? This is a strange sound for Indian equity fund managers.

“A fund manager must recognize that investors have made their asset allocation decisions and want us to manage their equity exposure. If an investor has allocated only a small portion in equity and finds that we are shying away from taking equity exposure in our equity funds, it does not serve his purpose.’ Therefore, it should come as no surprise that funds have overall kept cash levels between 4-5 per cent of assets over the past six months, according to data from All Equity Value Research.

There have been attempts to launch products that decide asset allocation based 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 are worth 5.65 trillion was in equity-oriented products at the end of September, with the remaining 11.5% in balanced funds. This brings us back to the weight of money argument mentioned by Bakshi. “The weight of money, like any other argument supporting higher asset prices, is a delicate one. What looks like a virtuous cycle now, could turn into a vicious cycle if the trend changes from inflow to redemption. “

Of course, it’s anyone’s guess as to when the tide might turn. Buffett compares it to Cinderella at the ball. “They (market participants) know that staying out of the fray – that is, continuing to speculate in companies that have huge valuations relative to future cash they will generate – will eventually bring pumpkins and mice. But they still hate to miss a minute of one helluva party. So, the giddy participants plan to leave just seconds before midnight. However, there’s a problem: they’re dancing in a room filled with clock hands. are not.”