Late to the party

It has taken almost two years of a strong bull run to lure investors back to mutual funds. New schemes have started mopping up large amounts of money, and there are many more mutual fund IPOs in the pipeline.

The data for February show substantial net inflows into existing schemes as well, but these have been more than offset by redemptions. Long-term investors who had put in their money years ago have taken advantage of the boom to exit.

But there is also a lot of churn taking place. Some of the money has probably been used to subscribe to new issues, because in a bull market these have given substantial gains on listing.

Moreover, many investors have been tempted by the promise of investing in mutual fund IPOs, on the false assumption that they are getting a bargain because these issues are at par.

Another factor pulling investors back to mutual funds has been their performance""most of them have comfortably outperformed their benchmark indices.

The upshot has been that while mutual funds have remained sellers for most of the rally, they have turned net buyers in 2005. All this could mean that the elusive small investor has finally come back to the market.

This rally has been different from previous ones. One difference is that while earlier bull runs, such as the 1994 IPO rally and the 1999 tech rally, led to mutual funds offering sectoral funds""IPO funds in 1994 and tech funds in 1999""this time most of the new schemes on offer are diversified funds.

That's because this rally has been broad-based, and mutual fund schemes have mirrored that trend. True, banking funds have done very well on the back of the re-rating of bank stocks, but then banks can be said to be a proxy for the economy as a whole.

Yet another difference has been the out-performance by mid-cap stocks, which has led to diversified mid-cap funds.

As a matter of fact, smaller mutual funds have outperformed the larger ones, because the former can have a larger proportion of their corpus invested in mid-cap stocks.

The larger funds are too big to put too much money in these stocks, given their lack of liquidity. Nevertheless, the diversified nature of recent mutual fund offerings will be good for the investor.

After all, one of the basic reasons for investing through a mutual fund is portfolio diversification, which reduces risk. When the stock market cycle turns, as it inevitably will, being invested in diversified funds will prove to be safer than exposure to a "hot" sector.

For the mutual fund industry, however, the late awakening of the retail investor is a challenge. That's because the global environment for liquidity is now much worse than a few months ago, with yields rising in the US and the dollar strengthening.

The worry is that foreign investors will take the opportunity to offload their shares to mutual funds, who will have to invest the funds collected within the next three months or so.

So while the return of the retail investor to mutual funds is welcome, and could provide support to the market, it's also a well-known adage in the market that when the small investor gets in, it may be time to sell.