The home run

The growing presence of mutual funds in the trading ring is making equities vulnerable to domestic turmoil

The increasing influence of mutual funds on stock movements is a welcome counter to the dominance of foreign investors. At the same time, it has given rise to a peculiar set of problems for Indian equities. Domestic funds have to reckon with around Rs 10000 crore of inflows every month. There is urgency for quick results as the difference in the tax rates on long and short-term gains is now just 5 percentage points. The regulatory cap on exposure to stocks implies constant search for new investment themes. The beneficiaries have included companies low on performance but with plenty of hints of great potential. Discoveries have a cascading effect as other investors copy the cues. It took the Securities and Exchange Board of India to dismantle the Ponzi scheme. Increased surveillance and regrouping of stocks as per their market cap rankings triggered a shake-up of portfolios. More than 1,500 small caps lost over half their value and over 100 mid caps between 20% and 50% from their 52-week highs by late October. The bounce-back of these stocks will depend on several factors. Bumper festive-season buying on the back of normal monsoon and fading of the GST roll-out pain will be the short-term signal. The satisfactory completion of the election cycle by end May 2019 will be the medium-term trigger. The second effect of the vote of confidence in mutual funds to create wealth is the lack of panic among retail investors to economic headwinds. A weak rupee is trapping an import-intensive India into a high interest-rate regime. The climbing up of fuel prices has hurt consumption but not the savings habit. The consumer price index has remained nearly flat in the three months to September 2018 though Brent prices rose over 17% to US$ 82.72 a barrel in the two-and-a-half months to end September 2018. The gross savings to GDP ratio has remained constant at around 29% in the last two years to the June 2018 quarter. The surge in SIPs shows no sign of slowing: they grew 52% in September 2018 from a year ago and 13% from April 2018.  The IL&FS crisis has been shrugged off after the government takeover. The smooth transition of Satyam and UTI to normalcy has put to rest for now fears of a blowout.

The third worry is the inability of mutual funds to sway large caps. Most of their expensive discounting stems from the inclusion in various widely-tracked indices, making them indispensable to foreign institutional investors. The pace of their appreciation or decline depends on the volumes of dollars chasing or exiting from them due to issues that affect liquidity rather than any company-related event. After languishing for the first six months of 2018, when mid and small caps were hitting new peaks, the headline indices raced to hit their lifetime highs in August after overseas portfolio managers turned net buyers. The fourth outcome is the comeback of local news in shaping the market. NBFCs were dumped on concerns of asset-liability mismatch despite healthy operational performance of all the front-line players. Their net profit improved 31% and the return on assets 0.3 percentage points to 1.9% in FY 2018. The chatter of how these lenders had occupied the retail loans space untended by PSU banks went silent. In a diametrically opposite strategy, big investors have voted for private banks despite corporate governance issues at most of them.  The Reserve Bank of India has denied extension to bosses of two private banks for hiding bad assets and pulled up two for not diluting their stake.

The fifth fallout of mutual funds being bestowed with the responsibility of outperforming the market all the time is the increasing trend of turning over portfolios to squeeze out maximum value by ejecting slowing stocks and spotting growth opportunities. The 24x7 news cycle that is constantly spewing information has only accelerated the trend. On an average, equity schemes churned 94% of their stocks in September 2018, up from 76% in January 2018. The frequent shuffling of the pack means higher trading charges and diminishing returns. If the growing demand resulted in heightened scrutiny of mid and small caps, the spurt in interest is triggering a close examination of the way mutual funds operate. The crackdown on floating of similar schemes will result in rapid rotation of stock allocation and volatility. Sponsors of asset management companies will be left with little choice but to shift focus to high-frequency portfolio management schemes, whose fees are linked to performance, or encourage passive investing. After equal preference, with Rs 8000-crore subscriptions each in June 2018, it will be interesting if the marked tilt towards active funds in September 2018, after the benchmarks touched their lifetime highs end August 2018, persists after the market's plunge since then.

-Mohan Sule