May 2017: Domestic investors to increase equity allocation over long term

Equity markets continued to gain in strength, with the Nifty up 3.4% for the month. After several months, we saw the small and midcaps weaken while the Nifty continued to forge ahead. Though corporate results continue to be a mixed bag, the strength in the markets seems to be based on the optimism around a cyclical economic recovery. This optimism also seems to reflect in domestic investor preference to invest further in Indian equities.

Equity markets were weak during the months of November and December 2016, due to concerns over the impact of demonetization as well as global factors, and since then been gaining in strength. One of the interesting behavior during this phase has been strong inflows by domestic investors, despite patchy flows from foreign investors. Historically, the Foreign Portfolio Investors (FPI) have been investing about $ 20 billion every year (2010-2015), and these flows had slowed down over the past two years (outflow of $ 2.1 billion in FY2016 and inflow of $ 8.6 billion in FY2017). On the other hand Domestic Institutional Investors (DII, which mainly includes Mutual Funds and Insurance companies) had invested negligible amounts in the 2010-15 period on a net basis, due to redemption pressures from domestic investors, but have been averaging about $ 10-15 billion over the past 2 years.

This increase in investments in equity markets by domestic investors is to an extent due to lower returns in the fixed income markets (bank deposits, liquid funds and other debt products), which is forcing investors to look for higher yielding instruments. In addition, continued weakness in real estate prices is further assisting these positive flows. Distribution reach of equity linked savings products is also becoming more efficient. We are likely to see increased flows toward equities in the coming years.

Despite the recent strong flows into equity markets, equities continue to be a relatively small proportion of savings for most Indian investors. The total equity linked assets with Mutual Funds is slightly less than $ 100 billion, which is relatively small compared to GDP of about $ 2.1 trillion, annual savings of USD 300 bln and penetration of equity Mutual Funds in other developed and emerging markets. This gap should reduce in the coming years, as awareness increases. Increase in distribution reach, a more efficient investor onboarding process, efficient payment infrastructure are likely to further aid the participation of investors in equity markets.

As Indian markets mature, we believe more domestic savings should gravitate towards equities, reducing the volatility and dependence on foreign investors. Moreover, with reduced return expectation from both fixed income markets and real estate, investor have little choice but to increase allocation towards equities. The recent market strength, has reduced the gap between intrinsic value and the market price and has exaggerated valuations in several pockets of the markets. In addition, a broad based corporate growth is yet to take place. On the other hand, a reasonable possibility of a cyclical recovery in the economy over the medium term makes equities a must own asset class.