In recent times, India’s bellwether stock indices — the Nifty50 and Sensex30 — have behaved like the proverbial cat with nine lives. Dire events such as US-Iran hostilities, trade wars, India-Pakistan face-offs and the global recession scare, have triggered only shallow corrections in the indices from which they have bounced back smartly. They’ve brushed off fundamental factors such as India’s worsening GDP growth print, repeated earnings misses by India Inc and sky-high valuations, to scale new highs.
The index behaviour has caused much heartburn for domestic investors. Retail investors, the bulk of whose money is parked in the mid- and small-cap segments of the market, have seen their portfolios lose value while the Nifty50 and Sensex30 have notched up double-digit gains.
While there is much gnashing of teeth over this disconnect between index behaviour and corporate fundamentals, it is neatly explained by the other big factor that powers stock prices — liquidity.
MFs amass assets
While Foreign Portfolio Investors (FPIs) have been blowing hot and cold on Indian equities in the last six years, domestic retail investors have warmed up to them in a big way. They have routed the bulk of their incremental equity bets via mutual funds.
Analysis on the shareholding patterns of listed companies (Capitaline) shows that from end-2013 to end-2019, the market capitalisation of Indian stocks expanded from ₹70 lakh crore to ₹157 lakh crore fuelled both by new flows and rising stock prices. In this period, the share of FPIs in the free float market capitalisation rose marginally from 39 to 40 per cent, while insurance companies saw their shares dip from 12 per cent to 9 per cent. Direct public holdings were flat at 16 per cent.
But mutual funds in this six-year span saw the market value of their equity bets jump more than fivefold from ₹2 lakh crore to about ₹11 lakh crore, doubling their share in the free float market cap from 7 per cent to over 15 per cent.
The stock choices of domestic mutual funds have therefore exerted big influence on stock price moves lately. So, where have they been investing all the incremental money?
Large-caps hog assets
As mutual fund managers have amassed assets in a weak earnings and economic environment, they seem to have leaned more and more towards large-cap stocks while retreating from the rest of the market.
In September 2013, when MFs managed just ₹2 lakh crore of assets, they had about ₹1.5 lakh crore invested in the top 100 stocks by market cap (large-caps by SEBI’s definition), ₹0.35 lakh crore in the next 150 stocks (mid-caps) and ₹0.15 lakh crore in the rest of the market (small-caps). In effect, they had a 76 per cent allocation to large-caps, 17 per cent to mid-caps and 7 per cent to small-caps.
In the next four years, as the rally took hold, they grew more adventurous to buy up more mid- and small-cap stocks. Between September 2013 and September 2017, MF investments in large-caps rose from ₹1.6 lakh crore to ₹4.8 lakh crore, but their bets on mid-cap stocks zoomed from ₹0.34 lakh crore to ₹1.4 lakh crore and to small-caps from ₹0.15 lakh crore to ₹0.75 lakh crore. By September 2017, they had 69 per cent in large-caps and 31 per cent in mid and small-caps.
However, SEBI’s re-categorisation exercise in October 2017 reined in excursions by large-cap equity fund managers outside their mandates, forcing them to prune mid- and small-cap holdings. Rising market uncertainty and correcting mid/small-caps simultaneously prompted even multi-cap funds, to up their weights in large-caps.
As a result, by December 2019, nearly ₹8.5 lakh crore of MF equity assets were parked in the top 100 stocks and ₹1.9 lakh crore in the next 150 stocks, with just ₹0.60 lakh crore in small-caps. Effectively, between September 2017 and now, MFs have withdrawn money from the rest of the market to plough it into the top 250 stocks. A good 77 per cent of MF equity assets are now in large-caps.
The Nifty race
A handful of Nifty50 stocks began to forge ahead of other large-caps from 2017 onwards, prompting many fund managers to further narrow their choices. As a result, of the ₹11 lakh crore equity assets managed by mutual funds in December 2019, Nifty stocks alone accounted for ₹7.4 lakh crore (68 per cent). This has climbed from ₹4 lakh crore (58 per cent) in September 2017. Pension fund investments in the indices have also added to this trend.
Other institutional participants have also followed a similar playbook. FPIs from September 2017 to December 2019, raised their holdings in the top 250 stocks from ₹22 lakh crore to ₹27 lakh crore while pruning small-cap bets from ₹2.2 lakh crore to ₹0.76 lakh crore. Insurers have ₹6 lakh crore invested in the top 250 and just ₹0.10 lakh crore in the rest of the market.
Of course, not all of these shifts in the market cap weights are the result of deliberate re-allocation by investors. Price gains in large-cap stocks have automatically raised their portfolio weights, while small-cap stocks have borne the brunt of a vicious cycle where heavy selling has led to tumbling prices. Evaporating liquidity in the smaller names has served to further push institutions away from them.
The market’s recent bipolar behaviour, where index stocks have refused to correct despite high valuations, and small-cap stocks have been drubbed for no good reason, is clearly the result of these trends.
The way out
The narrowing market can end badly for everyone concerned. Persisting pain in small- and mid-cap stocks can put direct retail investors in equities off for good. If valuations for index stocks turn untenable (they are bound to, if liquidity continues to chase them), the correction in the indices can be deep leading to capital losses for all recent investors in MFs.
Apart from reviewing its large, mid- and small-cap definitions (which SEBI is said to be working on), the regulator can look at funding research on small-cap companies from its investor protection fund coffers. It needs to encourage (instead of making life difficult for) the growth of Portfolio Management Schemes and other HNI vehicles that dabble in the small-cap segment of the market.
The mutual fund industry needs to do its bit too. A majority of fund managers today are devotees of large-cap, quality and momentum-driven strategies while value, contrarian and small-cap strategies are in the dog-house. But style diversity is critical to a good long-term return experience for investors. Therefore, AMCs may need to stop going with the flow and launch/promote funds with out-of-favour styles where buying opportunities are plentiful. SEBI must enable this by allowing AMCs to offer more categories of funds that go against the tide (value, contrarian, dividend yield can all be separate categories). More funds also need to rework their equity mandates to take cash calls or alternatively gate their inflows, to deal with situations where there’s too much money chasing a limited set of opportunities.