A fragile prop

All the data point to the fact that buying by mutual funds has been propping up the equity market. Foreign institutional investors have been net sellers in April and in the current month, while mutual funds have turned aggressive buyers.

Mutual funds have more than doubled their share in the combined total turnover of the Bombay Stock Exchange and the National Stock Exchange, and their net buying this month has been a record.

The upshot has been not only buoyancy in the Sensex, but also a much bigger rally in mid-cap stocks, as mutual funds targeted at these stocks get invested.

The main reason for the surge in mutual fund buying has been a spate of new schemes, which have mopped up substantial amounts of money. It is this money that is now getting invested in stocks.

Moreover, mutual fund net buying has been much higher than net sales by FIIs, indicating that operators too have been selling.

These trends raise several interesting questions. First, do they indicate that domestic mutual funds will be strong enough to propel the stock market upward, despite the lack of interest shown by the FIIs?

And second, what happens when no new schemes are launched by mutual funds? Taking the second question first, there has recently been a big increase in the number of draft offer documents filed by mutual funds with the Securities and Exchange Board of India.

In May, for instance, as many as thirteen such draft documents, the majority of them being equity schemes, have been filed with the market regulator.

To be sure, there has been a lot of churning in mutual funds, with investors getting out of the old schemes, and it's true that some gullible investors have put their money in new schemes under the mistaken impression that investing at a net asset value of Rs 10 gets them a special benefit.

But there's little doubt that, so far, the pipeline of new mutual fund issues is full, and there's a substantial amount of money waiting to be invested. At the same time, some of the new schemes that have recently raised money have not been doing very well, and a continuation of the lacklustre performance could take some of the shine away from new issues.

If that happens, the prop holding up the market would be removed. The case for domestic investors investing a larger portion of their portfolio in stocks has been a compelling one, given the fact that the proportion has been falling and because of the low returns available elsewhere.

However, a look at previous episodes when domestic mutual funds were net buyers is not very encouraging. Mutual funds were net buyers of equities in March, April and May 2000, when the tech rally peaked.

They also bought large quantities of stocks in December 2003 and January 2004, again at a peak. More recently, after being net sellers for much of last year, they were big buyers last December, before the markets fell in January.

In short, mutual fund investors are usually the last to buy, with the more savvy high net worth and institutional investors getting out of the market. That doesn't augur too well for the current rally.