Are mutual fund flows into equities at an inflexion point?

The equity market rally thus far this financial year (H1FY18) in the absence of a meaningful pick-up in earnings has been fuelled by the gush of liquidity, especially by the mutual funds, which have invested around Rs 70,500 crore during this period. This is five times higher than what they had invested in the corresponding period last fiscal.
 
While most of this money has found its way into the mid-and the small-cap segments of the market, analysts have now started to worry about how long can this flow continue in the absence of a pick-up in corporate earnings and a healthy growth in the economic activity. The recent deluge of net equity MF flows appears to be an outcome of a self-fulfilling virtuous cycle between inflating valuations and retail flows, they say.
 
Average monthly flows into equity MFs turned positive from May’14 – says an Emkay Global report co-authored by Dhananjay Sinha, Head of institutional research, economist and strategist at Emkay Global Financial Services along with Kruti Shah – averaging around Rs 5,500 crore and surged further post demonetisation to over Rs 10,000 crore.
 
Historical cycles, according to Emkay, indicate that booms in MF flows last for three years – equal to the duration of the current upswing. But, in contrast to earlier cycles, this time the rally is sans any material improvement in fundamentals.
 
“Previous booms of 1992-1996, dot com bubble and 2004-2008 suggest that triggers for a down cycle emanate mostly from global markets. High frequency data indicate that if FIIs remain net sellers for a long time, it would put at risk the present lofty market valuations, especially in the mid-cap index, which in turn can lead to redemption of MF flows,” the Emkay report suggests.
 
On the other hand, Sanjeev Prasad, executive director and co-head, Kotak Institutional Equities believes that the strong returns of the Indian markets over the past 6 – 12 months may have increased return expectation of retail investors (expected rate of return) and may be one of the reasons behind the recent large inflows into equity mutual funds. 

That apart, Prasad believes higher household financial savings may be the key driver of the large retail inflows into domestic equity mutual funds – a belief that Emkay Global, too, shares.

“Our analysis reveals high correlation (0.82) between the proportion of household (HH) savings flowing into equities & debentures and market valuation. Importantly, the peak level of HH participation in equity markets (1992-1996) saw the proportion of equities and debentures / HH savings rising to an average of 10% with PE ratio averaging 35x. During periods of declining valuations, HH participation has declined considerably to an average of 1.5% of total savings,” the Emkay reports says.

Large inflows into equities, according to Prasad of Kotak, could continue until the return and ‘cost’ expectations of retail investors change driven by: (1) a period of weak returns from the stock market, which will reset the expectations (expected rate of return) of retail investors to lower levels and/or (2) a period of good returns from other asset classes, which will raise the required rate of return of retail investors. 

He, however, cautions that the markets cannot keep on delivering returns beyond those justified by earnings growth and fundamentals forever.