Lower inflation will cap income from debt investments

India’s developments have become visible in all areas of economic activity. For a very long time, I remember in my school days, teachers used to say that, inflation in our country is high which posses a big challenge to save money. Slowly this challenge is becoming a myth, we have successfully brought down the inflation rates to below 4% levels.

When Raghuram Rajan talked about this a couple of years back, media brushed aside saying that, it is not going to be easy. Now, as we have reached the goal and beyond, we are looking at a newer challenge. When inflation is low and bank rates are high, real return in the economy is also high. This brings the challenge of having to pay higher taxes on income earned from debt investments which qualify for indexation benefits as well as assets like Real Estate.

In 2014, the debt returns were at 8.7% and tax payable was NIL after indexation. In 2017, the returns is almost the same, where the taxable portion of the income has moved up to ₹15742. Which means more than 50% of the returns will be taxed at 20%, thereby bringing down the net returns by more than 10%.

It is interesting to note how new challenges are coming up in life. If inflation stays low and the bank rate does not come down, taxes on debt fund returns will go up making the net gains reasonably lower. Investors in debt funds will have to re-think their investments.

They will also look to Equity funds which is already getting over crowded. Presently running at about 6 lakh crores and with expectations that there is going to be big inflows due to poor FD returns. Fund managers will now have a bigger challenge on stock selection and allocation of funds.

As it is MF’s are holding cash to the maximum permissible limits, presently a scheme can hold 10% cash. When holding cash in anticipation of a correction, if the market keeps moving higher, all these funds or schemes will have under performance against the broad markets. To avoid investors wrath, fund managers will be forced to invest into stocks that are fundamentally poor, thereby attracting very high risk on the investments.

If markets change course, the retail money that has flocked the Indian Mutual Fund industry will begin to move out, again giving the next challenge of meeting redemption pressures.

As the returns from debt funds are going to become lower due to taxes, what can be the next best alternative. Arbitrage funds will be the next place where we will see high inflows. Arbitrage funds are giving returns that are about equal to the prevailing bank rates for Fixed maturities, the biggest advantage they have is the tax free status or Equity taxation status.

Whereas, Arbitrage cannot absorb big flows as the edge to get returns will move away with huge capital chasing the same instruments in the market, which will bring down returns. As every other door to big returns will get locked as an automatic process, investors will be facing a situation of having surplus liquidity and not knowing what to do with it.

Bank rates coming down or inflation moving up is a requirement to keep things as they are, even this condition will require that, the fund flows into the mutual fund market requires a slowdown. All of a sudden the whole country put all their savings into one asset class will for sure ensure that the asset collapses on its own weight. Beyond our inflows, foreign money is also chasing Indian markets big time. FPI limit of 51b$ has got exhausted as I write this article and RBI is thinking to open another 2b$ for FPI’s.

One more change that could come is the returns on debt funds will begin to decline, which is inevitable & get self adjusted.

Investors beware, quality of your investment needs to looked at on highest priority. Just going to a website and selecting the top ranked fund will no more give the best returns. People need to take help of advisers while doing their investments. soon, we will have analysts who will research and find good Mutual Fund Schemes for investments.

Valuations are high…

SIP’s per month has increased from 3000 Crores in March 2016 and about to reach 5000 Crores per month. As this news comes out, the way it is getting received is a little different. The advantages that this high flow brings is that the Fund Managers now have a better option on allocations, where in the early times the retail flow will come when the markets are at high’s forcing the Fund Managers to buy risky stocks and sell the good stocks due to liquidation pressure as the retail money will move out, because they cannot find takers for ill-liquid risky assets.

“SIP flows are really good for us (fund managers); it helps us to calibrate money better,” said Gopal Agrawal, Chief Investment Officer-Equities, Tata Mutual Fund. He added that SIP route is the best option for investors currently when valuations look stretched.

Agrees Gautam Sinha Roy, Senior Vice President and Equity Fund Manager at Motilal Oswal Mutual Fund. “Visibility on inflows helps fund managers take long term calls, and that translates into performance at some point.”

Equity benchmarks have risen roughly 20 percent so far this year, defying sluggish macroeconomic data, geopolitical tensions, foreign fund outflows and expensive valuations. Assets managed by pure equity schemes now stand at Rs 5.73 lakh crore, accounting for roughly 28 percent of total mutual fund assets.

The bull market is not showing any signs of cooling off yet. And that appears to be drawing in retail investors by the droves, if the numbers are any indication.

Close to Rs 5,000 crore of SIP money flowed into equity schemes in July this year, up from around Rs 4,100 crore in January.

All asset management companies together have about 1.52 crore SIP accounts through which investors regularly invest in mutual fund schemes.

Last year, about 6.26 lakh SIP accounts were added each month on average, with an average SIP size of about Rs 3,200 per account.

In FY18 so far, the industry added about 8.23 lakh accounts each month, even as the average account size has not changed much.

“Many investors who had burnt their fingers in the last rally by directly investing in equities without proper research are now taking mutual fund route.” Tushar Bopche, Vice President, Products, IIFL.

Falling returns from traditional investment avenues like fixed deposits, real estate and gold is one of the main reasons for the massive inflows into mutual funds. An equally important driver has been demonetisation. Strong inflows have triggered a virtuous cycle wherein rising stock prices are attracting more money.

From playing second fiddle to foreign funds till some time back, mutual funds now have transformed into a credible counterweight to overseas money managers. This was evident in August when close to Rs 15,000 crore of net selling by foreign funds did not have much of an impact, thanks to purchases by domestic mutual funds.

And yet, some fund managers are hoping that the industry does not become a victim of its own success.

“Inflows are strong right now, but one can never say how investors will react if the market underperforms for two or three years at a stretch,” says Rajeev Thakkar, CEO, Parag Parikh Financial Advisory Services.
Traditionally, retail investor frenzy has marked the peak of a bull run. That trend no longer seems to hold true, looking at the sustained uptrend in stock prices even as retail money has been gushing in through mutual funds.

But not everybody is convinced.

“Where was this retail money when the market was cheap,” says a fund manager who did not want to be quoted.

“The inflows are rising as the market is climbing. Valuations are already expensive, but since the trailing returns look great, everybody seems to be convinced that the future returns will be as good. Most people are not aware about the product they are buying into. This is a classic sign of an approaching market peak. But that may not happen tomorrow or the next month. You could even see monthly SIP inflows climbing to around Rs 8000 crore per month before realization sets in that stock prices are hopelessly inflated,” the fund manager said.

These above thoughts are bringing concerns, not to be pessimistic when the world around is optimistic, just a thought on the other possible conditions too.

Mutual Funds are getting more popular, money flow is really really high. All of the once conventional investors as well as people who did not believe on the concept have now accepted it as a top of the kind investment. When some thing gets overdone, it gets counter productive. Fund managers fear the same in Mutual Funds too.

Today we have around 700 plus mutual fund schemes while there are only about 1600 active stocks in our market. So many variants, that, very soon, people will have challenges in getting what was actually to be got. Like how we have good analysts to pick the best stocks, we will soon require analysts to identify best funds.

Few people will be successful in getting better returns while others will keep complaining or blaming, now the blame will get bigger and more vibrant. For stocks, brokers and tip providers were at fault. Now AMC’s for wrong marketing, Fund Managers for wrong positioning, IFA’s or adviser’s for miss selling and many more will follow.

Going forward, investors will require the help of analysts to invest and earn from mutual funds. The thoughts shared here are very early foresight, it will take time to reach such levels.