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Aarati Krishnan

Equity fund sales are picking up... But it remains to be seen whether the queues will shrink if the bull phase ends.

RECENT trends in mutual fund flows suggest that the Indian investor is regaining his appetite for equities. But is he willing to make them a part of his regular diet? The evidence on this is not conclusive. For this, the robust inflows into equity funds since 2003 will have to be sustained through the ups and downs of the stock market.

Equity funds are certainly making a comeback, judging by their sales numbers over the past year and a half. Equity funds notched up average sales of about Rs 2,700 crore a month in 2004. This is a hefty 70 per cent increase over the number for 2003 and about five times the monthly sales registered during the bull market of 1999.

With new investments steadily building up the corpus and rising equity values lending a helping hand, equity funds have doubled their asset base over the past year.

Consistently higher sales

Sales numbers have also been more consistent than they have been at any time in the past. Since August 2003, the monthly sales have consistently remained above the Rs 1,800-crore mark, except in one month. This is a healthy sign, as inflows into equity funds in the period before 2003, tended to yo-yo month to month.

With fund sales keeping up a steady tempo the last 18 months, market watchers are drawing a parallel with the American experience of the 1980s. Then, rising household incomes and a steady acceleration in fund sales saw the household penetration of American mutual funds climb from 5 per cent to over 20 per cent in just six years.

Yet to be tested

But an analysis of trends in Indian mutual fund flows over a five-year period shows that it may be early days yet to expect such a jump. It is only in the 22 months since August 2003 that equity fund flows accelerated sharply, and this has been a particularly buoyant period for the stock market.

Judging from the experience until 2003, investors appear typically comfortable entering an equity fund midway through a stock market rally, when the NAVs (net asset values) are trending steadily upwards. Few investors venture into equity funds in a moribund market, confident that they will gain upon recovery.

Robust monthly inflows into equity funds usually follow a month or two of good stock market returns. In this respect, the period since August 2003 has been quite conducive to equity fund sales. The stock market has either notched up positive monthly returns or has stayed flat in 18 of the 22 months between May 2003 and February 2005. With the market marching predictably upwards and the returns on equity funds outpacing the market by a big margin, recent investors have tasted the rewards of equity investing, without experiencing its risks.

Warts and all

So, while investors are now allocating a larger portion of their savings to equities, it is not clear if this represents a sustainable trend. The recent pace of inflows into equity funds will be tested if the market witnesses a sharp reversal. Over the past year and a half, there was just one month when the stock market suffered a significant reversal. In May 2004, the Nifty lost 17 per cent in value, on post-election jitters. Sure enough, the following month was the only one in recent history when equity fund sales plummeted below the Rs 1,800-crore mark. They were at Rs 912 crore.

True, smaller corrective phases in the market, such as in January 2004 or in January 2005, had no noticeable impact on equity fund flows. But before concluding that more Indian investors are now willing to make equity funds a part of their portfolios, we would have to wait for a corrective phase that lasts longer than the previous one did.

No panic on pullouts

In contrast, the pattern of redemptions or pullouts from equity funds in recent times does show that, once in, fund investors are a patient lot. Equity funds do not seem to experience any panic pullouts in the midst of, or even after, a sharp corrective phase in the market.

If equity fund sales slumped in June 2004, so did the pace of redemptions. Pullouts from equity funds, which hovered between Rs 1,500 and Rs 2,500 crore a month over the preceding 12 months, shrank to Rs 906 crore in June 2004 following the stock market rout in May.

But investors do seem to use a buoyant phase in the stock market to cash in on their fund investments. As the market climbed, monthly pullouts from equity funds also picked up pace over the past year and half, though they remained at much lower levels than the inflows.

This is probably healthy for the mutual fund industry over the long term. Traditionally, the bulk of inflows into equity funds has come in at, or close to, peaks in the stock market. As a result, investors who entered equity funds in 1994, end-1999 or early 2000 have probably had to wait several years to earn a reasonable return.

The steady pace of pullouts from equity funds in recent months signals that a good number of these investors may be trying to exit from their investment. This trend could help mitigate the poor experience that many Indian investors seem to have with investing in equity funds, despite the latter's good return numbers.

Lower churn

Another welcome trend is the reduced rates of churn — the proportion of inflows and outflows to equity fund assets. With the equity assets rising sharply over the past year, flows into and out of equity funds have caused fewer upheavals in fund size in 2004.

After rising steadily through 2003, monthly inflows and outflows taken together accounted for as much as 33 per cent of the average equity fund assets in December 2003. Such a high proportion of inflows and outflows from an equity fund may not be healthy from the investors' perspective. It could force the fund manager to replace a large proportion of the stocks in his portfolio at a time when market conditions are less than ideal.

But with the assets managed by equity funds swelling sharply over the past year, inflows and outflows, as a proportion of the fund size, have been waning. By February 2005, the churn rates for the inflows and pullouts taken together added up to just 20 per cent of the average assets. This shows that fund managers probably have to contend with lower volatility on the corpus they manage now, than was the case a year ago.

Disconcerting trend

However, the one disconcerting feature of the recent inflows is that new funds garnered a significant portion of the money flowing into equity funds. Over the past year, about 16 per cent of all inflows into equity funds (or Rs 5,168 crore) poured into initial public offerings from fund houses. Though old funds with an established record have garnered much more (Rs 27,000 crore), investments routed through an IPO suffer from a couple of disadvantages.

One, many investors who take the IPO route make one-off investments in equity funds and are not regular investors. This may not be the ideal way to invest in equity funds, as the returns from such an investment would depend heavily on the timing of the IPO. Should the market enter a corrective phase, these investors may be vulnerable to a sharp erosion in the value of their entire investment.

Two, many investors who prefer a new fund over an established one do so under the mistaken notion that entering a fund at an NAV of Rs 10 reduces the downside risk associated with an equity investment.

These investors may be less prepared (than those who invest in established funds) for a blip in the value of their investments, in the event of a market correction.

Instead of rolling out new funds, fund houses need to put greater effort into persuading investors to place faith in established funds that have a good track record. Regular monthly investments in mutual funds also need to encouraged, rather than one-off investments prompted by a booming stock market.

They have made a beginning on this, by announcing entry load waivers on investments routed through the systematic investment route.

If the fund industry, through its distributors, does manage to convince a larger proportion of investors to make systematic investments in equity funds, one can look forward to fund flows that are not too influenced by the ebb and flow of the stock market.

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