Why mutual fund inflows aren't enough to counter Indian market volatility

The accelerating pace of equity supply is the key reason domestic equity markets are again developing a vulnerability to the volatility in foreign flows.

Indian equities, which had largely been shielded from market volatility over the past few years thanks to strong macros, robust earnings, and consistent domestic inflows, are now facing a tough challenge. The past month has witnessed a sharp 8% drop in benchmark indices, with the broader market seeing even steeper corrections. As of November 5, 2024, over 125 stocks in the NSE 500 index have dropped more than 25% from their recent peaks, showed an analysis by Axis Mutual Fund. 

 

The Role of Foreign Institutional Investors (FIIs):

 

A key factor behind this market downturn is the significant outflow of foreign funds. In October 2024, FIIs pulled out $12 billion, reversing the positive trend seen in the previous two fiscal years. This abrupt shift in foreign sentiment has put pressure on Indian equities, despite strong domestic inflows.

 

 

Domestic Flows: A Double-Edged Sword

 

This market swing is particularly surprising considering the sustained and strong inflows into domestic mutual funds (MFs). In September alone, domestic mutual funds saw inflows of Rs 344 billion (US$4 billion), and in the first half of FY25, mutual funds recorded a massive US$30 billion in inflows. SIP flows have also reached new heights, with a monthly investment of Rs 245 billion (US$2.9 billion) in September, continuing into October, showed the analysis. But they have not been sufficient to offset the impact of FII selling. The increased supply of equity shares through IPOs, QIPs, and secondary market sales has further exacerbated the situation.

 

Foreign Selling: A Major Driver of Market Downturn

According to market experts, the primary driver of market downturn has been foreign selling, which reached an unprecedented US$12 billion in October alone. This was a sharp reversal in sentiment compared to the previous fiscal year when foreign institutional investors (FIIs) had been net buyers of Indian equities.

 

Several factors have contributed to the outflow of foreign capital, including disappointing earnings reports, rising US 10-year yields (up by approximately 80 basis points since mid-September), a stronger US dollar (which has appreciated by 4.2%), and shifts in global capital flows towards Chinese and Japanese markets. These factors have all played a part in dampening the appetite for Indian equities among foreign investors.

 

Ashish Gupta, CIO of Axis Mutual Fund, noted that while domestic flows have remained strong, they are no longer sufficient to counter the impact of foreign selling and the increasing pace of equity supply. "Markets have seen volatility even with strong mutual fund inflows, and the risk now lies in the rising supply of equity, which outpaces the steady inflow into domestic funds," Gupta explained.

 

Equity Supply Surge Outstrips Mutual Fund Inflows

Another major theme impacting Indian equities is the increasing pace of equity supply, which has created a vulnerability in the market. During Q2 FY25, the supply of equity in the form of IPOs, Qualified Institutional Placements (QIPs), and secondary stake sales from promoters and private equity amounted to US$21 billion (Rs 177,000 crore), significantly outpacing the $18 billion (Rs 142,000 crore) that flowed into equity mutual funds.

 

This surge in supply has been particularly evident in the primary market, with IPOs and QIPs reaching a record US$4 billion (Rs 33,000 crore) in Q2. In addition, secondary sales from private equity and promoters accounted for a large portion of the total supply. While foreign investors have been net buyers of a portion of this supply, the increased market supply is straining the domestic mutual fund inflows, which have traditionally played a significant role in absorbing such equity raises.

 

The situation looks set to worsen in the second half of FY25, with an IPO pipeline nearly three times the amount raised in the first half. A total of 91 companies are preparing to raise US$17 billion through IPOs, and another 70 companies are in the process of raising US$16 billion via QIPs. The secondary stake sales are also expected to continue at a similar pace, contributing further to the increased supply. In total, the equity supply in the second half of FY25 is expected to reach $55 billion, more than double the estimated inflows into mutual funds.

 

 As supply outstrips demand, the market may face downward pressure, and domestic mutual fund inflows may not be enough to offset the supply glut, leaving the market increasingly vulnerable to the vagaries of foreign flows.

 

The rapid pace of equity raising could, however, signal a broader shift in the investment cycle. In contrast to previous cycles that were primarily debt-fueled, this cycle is expected to be more equity-funded, with US$39 billion raised by corporates through IPOs and QIPs in the past 18 months. 

 

This large capital-raising activity could contribute to further investments in capex and acquisitions across various sectors, including power, real estate, IT, healthcare, retail, and auto.

 

"The breadth of companies looking for capital is wide. Power sector (US$4.7 bn) and real estate (US$4.1 bn) stand out with largest capital raises each planned for this year. Services companies (IT, Logistics) at US$2.3 bn, Retail (Q-commerce, FMCG) US$2.9 bn, Healthcare at US$2.3 bn, metals at US$2.2 bn and auto at US$3.1 bn are other sectors witnessing material capital raises," noted the report.