Rising Mutual Fund inflows – Headed for a bubble?

Historically, foreign investor flows have been by far the biggest driver for Indian markets. However the past couple of years have seen a quantum jump in the size of domestic fund flows as the financial investments business begins to gain critical mass.

Consequently, we introduce a few charts which we would track on an ongoing basis in order to determine non-fundamental market factors which could influence portfolio allocations and returns.

Flows into domestic equity funds

2014 – 2016 can also be earmarked as the period where the dominance of foreign investor flows in the Equity markets started to wane relative to the growing importance of Domestic institutional funds.

The quantum of flows into Domestic equity mutual funds is starting to match the size of foreign institutional investor flows into Indian equity markets.

Additionally the negative correlation between the flows from the two investor categories has been increasing (-0.55 over the last 3 years v/s -0.35 in the period from Jan 02 to Dec 16).

Due to a decrease in preference for investments into traditionally favored asset classes like Real estate and Gold, mutual funds are emerging as one of the primary investment avenues for investors based in India.

But is this indicative of a bubble in fund flows in the domestic mutual fund industry?

The below chart shows that the flows into domestic Indian Equity Mutual Funds is still only + 1 sigma standard deviation from the mean. This compares with a + 3 sigma or higher standard deviation during the 2005 – 2006 period which statistically suggests an extreme i.e. bubble in equity fund inflows. The positive fund flows over the 2014 – 2016 period also follows a long period of 6 years from 2007 – 2013 when the domestic Indian mutual fund industry saw continuous outflows.

This suggests that from a statistical point of view, there is likely sufficient headroom for an increase in flows into domestic equity mutual funds.

Can these fund flows be an indicator of future returns?

The jury is a little out on this question.

The previous bull market between 2003 and 2007 saw a positive attribution to Returns based on inflows into domestic Indian equity mutual funds in the previous calendar year. However this trend went the opposite way since the crisis until 2015.

As the weightage of the domestic Indian equity mutual fund investor increases in the overall scheme of things, one can expect this factor attribution to become stronger. This data only captures Indian domestic equity mutual funds and does not include flows into the Insurance industry.

In Summary

Fund flows are often a big driver of returns as they flow into assets, thereby raising their prices and in-turn forcing other market participants to follow suit. A classic case of “tail wagging the dog” ensues as assets whose prices are rising are considered as sound investments. We are still in the early stages of becoming a market where domestic fund flows become a larger force than global fund flows in India. The relative lack of attractiveness of real estate and gold along with low FD rates will hasten these flows which in turn may drive markets. Consequently tracking fund flow charts can prove to be a useful indicator to gauge strength of likely market movements, sustainability of flows and potential bubbles.