Market slowdown explained: Debt funds outperform equity after 2 years

For the first time since May'23, Debt funds have started outperforming Equity funds on 1-year rolling period.

Debt funds have begun outperforming equity funds for the first time since May 2023, marking the end of a two-year trend This trend reversal, noted by analysts at Elara Capital, suggests that equity markets may be entering a period of prolonged weakness. The performance of debt funds has been a key indicator of this shift, signaling potential headwinds for equity markets in the coming months.

 

For the first time since 2011, debt funds are seeing a 1-year rolling period outperform equity funds, and the underperformance of equity funds in February 2025, which reached 4.7%, marks the largest gap since 2018. Historically, such periods of underperformance in equity funds have been followed by multiple rounds of correction in the stock market, suggesting that a similar phase may be underway. 

 

Adding to the concern is a growing trend of underperformance in active funds compared to passive funds. Active strategies, which typically involve more flexibility and active management, have struggled to keep pace with the more stable and predictable passive funds. This marks the first significant instance of active funds underperforming since 2023, with earlier periods of similar performance seen in 2011-2014 and 2018-2020. During those phases, large-cap stocks, especially those within the Nifty Top-10, led the market's outperformance. This trend could be another indicator of a weakening equity environment. 

Shift Back to Larger Names and Weaker Market Breadth

 

 

Further signs of a deteriorating equity environment are emerging with the shift in index weights back to larger names in the market. The weight of the top 50 stocks in the NSE500 index has been steadily increasing since May 2020, indicating a growing preference for larger companies over smaller ones. This trend of market polarization is often a leading indicator of weak economic or earnings growth ahead. Historically, such phases of market polarization have been accompanied by weak market breadth and sideways or correcting markets, which signals that investors may want to reallocate funds towards large-cap stocks to avoid further underperformance.

 

This shift is reminiscent of previous market downturns, including those seen in 2008-2009, 2010-2013, and 2018-2020, when smaller companies underperformed, and liquidity in mid and small-cap stocks faded. As this trend continues, it suggests that investors should be cautious about smaller-cap stocks, which could face additional pressure as liquidity dries up. 

Addition of new folios– Smallcap folio addition rate drops to 2-year low. Midcap & Thematic also plunge

 

Rate of new folio addition in Mutual funds gives an indication of the breadth of Retail participation. While flows will be influenced by the size of the investor, new folio addition will be a better reflection of breadth of investor participation.

 

"In Feb’25, Equity funds saw addition of 1.8 million folios, which is the slowest monthly addition since November 2023. This was largely on back of slowest folio addition in Midcap, Smallcap and Thematic/Sectoral funds. What is more concerning is that bulk of new investors in Midcap and Thematic/Sectoral funds came into markets post election results of June 2024. And a meaningful portion of these investors are already sitting on losses. Although, we have still not seen much impact on flows, these could be initial leads of flows turning weak going ahead," said Sunil Jain of Elara Capital.

 

 What this means: Of concern is the fact that many of the new investors in mid-cap and thematic funds entered the market after the June 2024 election results and are now sitting on losses, indicating that investor sentiment may be weakening.  Cash levels surge:   Another worrying sign for equity markets is the sharp increase in cash levels held by fund managers, particularly in mid-cap and small-cap funds. Cash levels in large-cap schemes have expanded to 4.8%, the highest since June 2023, while mid-cap and small-cap funds have seen similar increases. The total cash held across all active equity schemes now stands at Rs1.74 trillion ($20 billion). Rising cash levels as a percentage of free-float market cap reflect a lack of conviction among fund managers, potentially due to fears of further market declines and a slowdown in retail flows.Changes in Mutual Fund Allocation and increased focus on large caps  

 Mutual fund allocations change   In line with these developments, mutual fund allocation is also starting to shift, particularly in the Flexicap schemes, which allow more flexibility in investing across market caps. These schemes have seen a slight reduction in their allocation to small-cap stocks, now holding 10.5% of their assets in small caps, down from 12% in October 2024. This is a significant trend as Flexicap funds are typically seen as a bellwether for investor sentiment. As the allocation to small-cap stocks decreases, the focus is shifting more toward large-cap stocks, suggesting that fund managers are preparing for continued market uncertainty.

 

Signs of Domestic Panic in the Market

 

Finally, one of the most telling indicators of potential market instability is the rising percentage of equity schemes hitting their 52-week lows. Historically, such spikes have been an early sign of a larger market downtrend. In March 2025, the percentage of equity schemes hitting their 52-week lows surged to 45%, signaling an initial panic among investors. Previous cycles, such as in 2008, 2011, and 2018, saw similar spikes followed by more significant corrections. If this trend continues, the market may experience a deeper sell-off in the near future.