There is a trade war simmering, the rupee is on weak ground, crude oil price remains at elevated levels, inflation is rearing its head, interest rates are moving higher and there is growing political uncertainty due to upcoming elections. But despite these growing pile of negatives, the Sensex and the Nifty have been sprinting higher, recording fresh life-time peaks every other day.
This Indian rope trick by the bellwethers has onlookers gaping in disbelief for it is clear that these indices are not representing the true condition in the stock markets.
A sharp correction had gripped the mid- and small-cap stocks since May that had severely eroded investors’ portfolios. As a result of this decline, 80 per cent of the 1,850 stocks actively traded on Indian exchanges, have recorded negative returns since the beginning of 2018. More than half the listed stocks have lost more than 20 per cent of their value and around 284 stocks have lost more than 50 per cent. Against the back-drop of this large-scale destruction in value of Indian stocks, the rally in the Sensex and the Nifty strikes a discordant note.
Global equity markets have also been jittery with the foreign investors pulling money out due to tightening liquidity conditions. But while benchmark indices in many Asian countries such as China, Indonesia, South Korea and Malaysia have recorded negative returns in 2018, the Indian bellwethers are defying gravity, despite FPI flows in to Indian equity turning negative this year.
This strange behaviour of the Nifty and the Sensex is largely due to the continuing flood of money that is being pumped in to Indian mutual funds by domestic investors. Fund managers are parking the money in larger stocks, in order to play safe in a turbulent market, thus driving up the Sensex and the Nifty.
MFs in Catch 22 situation
Mutual funds have become the largest source of incremental fund flow into Indian equity since 2015. While FPI flows have been declining due to tighter liquidity conditions caused by global central bank tightening, domestic MFs have been awash with funds over the last three years.
Thanks to aggressive marketing by AMFI and upbeat market sentiment post-2014 election, Indian savers have been pouring money in to mutual funds through the SIP (systematic Investment Plan) route. But since SIP inflows continue, irrespective of market conditions, funds are now faced with incessant flow of unwanted money. While FPIs net sold ₹4,167 crore of stocks so far in 2018, mutual funds have purchased ₹73,904 crore of stocks, till the last week of July 2018.
As the inflows have continued, fund managers have been forced to deploy the funds in stocks, despite fewer options available at peak levels. MFs are now chasing a handful of stocks with relatively better prospects, thus driving up the valuations of these further.
Since the Sensex contains 30 of the largest and most traded stocks in the Indian market and Nifty is composed of 50 of the largest, it goes without saying that the stocks that mutual fund managers prefer are part of these benchmarks too.
MF portfolio concentration
A closer look at the stocks held by all mutual fund houses, across schemes, throws more light on the dilemma that the funds are currently facing. Towards the end of June 2018, MFs held stocks valued at ₹9,07,659 crore. Of this, 68 per cent of the holding, valued at ₹6,21,250 crore, was parked in large-cap stocks, that are the top 100 stocks, ranked according to market capitalisation. About 18 per cent of the MF assets were invested in mid-cap stocks and only 13 per cent in small-cap stocks.
The relatively conservative profile of the Indian investors would have made more money flow in to large-cap funds, since these are perceived as less risky. It’s also possible that given the volatile market conditions since the beginning of this year, incremental investments by fund managers have mainly been in larger stocks.
Within the large-cap universe too, the options have been declining for mutual fund managers. For earnings of a few sectors such as real estate, pharmaceuticals, power, infrastructure and so on have been hurt by cyclical slow-down as well as regulatory issues.
Fund managers have therefore been flocking to select stocks that have been recording good earnings growth despite the tough market conditions. On the whole, mutual funds have invested in around 1,000 stocks.
Of these, the top 20 stocks by market capitalisation have attracted 42 per cent of the MF assets deployed in equity. Almost 58 per cent of the MF assets allocated to equity are, in fact, concentrated in just 50 stocks.
A quick glance at the stocks that top the MF holding list — HDFC Bank (5.87 per cent of equity holding), Infosys (3.67 per cent), ICICI Bank (3.45 per cent), SBI (3.01 per cent) and Larsen and Toubro (2.86 per cent), RIL (2.2 per cent), TCS (1.57 per cent) — shows that these stocks are behemoths that are considered safe bet for the long term. These are also the stocks that drive the Nifty and the Sensex.
The implications
Going ahead, the situation could get quite interesting. The flows in to MF SIPs are likely to continue, even if a meaningful correction begins in large-cap indices. For, it has been drummed in to investors that they should continue investing irrespective of market conditions.
This will mean that mutual fund managers will continue to hold investable funds even during market corrections. Deployment of these funds will cushion market declines, leading to shallower corrections in the Nifty and the Sensex.
This is already being witnessed in Indian markets. The Sensex has not witnessed a correction of more than 10 per cent from its peak since February 2016.
The Centre needs to spend some serious thought on increasing the supply of securities in Indian markets to meet this growing demand, otherwise valuations in large-caps could move in to the bubble-zone. Speeding up PSU divestments can help absorb some of these flows. SEBI too needs to pay attention to the imbalance in the demand-supply equation and consider limiting investments by some of the larger institutional investors, if necessary.