Higher flows and rich valuations push cash levels of mutual funds

51% equity schemes have witnessed non-equity holdings rising in the past year

The surge in flows into equity schemes in the past few months and rich valuations may have propped up their non-equity holdings that include cash and cash equivalents, as well as investments in debt instruments.  The BSE Sensex and the Nifty50 have risen 9.4 per cent and 12 per cent year to date (YTD), respectively.
 
Nearly 51 per cent, or 236 of the 465 equity schemes that were considered have seen their non-equity holdings rise in the past year, the data from Value Research shows. These include several small- and mid-cap schemes, focussed funds, and schemes belonging to the flexi-cap category.
 
Of these, 15 have seen their non-equity portion rise by more than 5 percentage points. As many as 86 schemes had non-equity holdings in excess of 5 per cent as of May 31, 2021 compared with 72 at the end of December 2020. As a percentage of total equity scheme assets, non-equity holdings have risen to 2.69 per cent from 2.27 per cent in the same period.
 
 Last year, schemes that were sitting on a lot of cash deployed it after the market crash in March and April as the pandemic gained momentum in India.
 
After July last year, the unlock process picked up and it became clear that the damage to the economy would not be as bad as earlier anticipated. Foreign portfolio investors became net buyers again and domestic fund managers realised that the liquidity-driven rally was here to stay.
 
This year, the markets have continued their upward trajectory, hitting new highs, despite the onset of the second Covid wave.

 
"In the past few months, fund houses have seen a surge in flows. Some schemes may be deploying this money very gradually as valuations remain stretched, resulting in higher cash levels," said Vinit Sambre, head of equities and fund manager, DSP Investment Managers.  The last three months have seen net inflows in excess of Rs 22,600 crore in equity schemes.
 
According to Sambre, valuations in the small- and mid-cap space particularly look stretched, limiting opportunities for fund managers somewhat. A large part of euphoria around these stocks could be attributed to the greater retail participation seen since last year, he said.  “Our equity schemes, in general, do not hold a high proportion of cash and non-equity holdings, and remain fully invested. Our mid-cap and small-cap schemes, however, may hold 5-8 per cent cash as liquidity buffer,” Sambre said.
 
The decision to increase cash or non-equity holdings goes against the fundamental tenet of staying invested at all times but is employed either to protect the downside in the event the market falls or to avoid paying a high price for a stock. Most equity schemes don’t typically take active cash calls, but on the assumption that investors have done their asset allocation and want to remain fully invested.
 
“Funds can’t hold cash all the time as it can be a drag on returns. Some amount of cash deployed at the right time can enhance returns. Even at very attractive levels, we keep 3 per cent cash so that we do not have to buy and sell stocks all the time, which can result in higher impact cost,” said Rajeev Thakkar, CIO, PPFAS Mutual Fund.
 
As of May 31, 2021, Parag Parikh Flexi Cap Fund had 65.53 per cent invested in Indian equities, and 28.52 per cent invested in foreign equities. The non-equity portion stood at 5.95 per cent as compared to 2.79 per cent a year ago.
 
“We also do not force ourselves to be fully invested at all points in time and may have cash equivalents and/or arbitrage positions in our fund... To the extent that we are not in the hottest sectors of the moment and that we may see some build-up of cash in the portfolio, the fund could see some underperformance in the near term,” Thakkar observed in a note sent to investors this month.
 
Non-equity holding may remain high for a while given the concerns about valuations and the impact on earnings growth because of the second wave of the pandemic and rising raw material prices.  “While the valuations of Nifty50 companies are rich as compared to historical averages, there are pockets of reasonable valuations in sectors like financials, health care, IT, and agri inputs. We believe one way to address the anxiety with respect to higher valuation would be to moderate the return expectation for the short-term and increase the time horizon in the markets as the earnings growth over next few years will lead to normalisation in valuations,” said Sambre.