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A Behavioural Trap

Investors rush in when the markets rise, hang around when they fall, and then rush out when they recover their losses.

It wasn’t too far back that the mutual fund industry reached Rs 5 lakh crore in size again after the financial crisis and as of now, this figure has already touched Rs 8 lakh crore. On the face of it, this seems like a remarkable rate of progress, and duly figures in newspaper headlines. In recent months, the progress past various round numbers has been particularly rapid. Rs 6 lakh crore was crossed in May, Rs 7 lakh crore in August and now Rs 8 lakh crore in November.

A casual headline-reader—which means most retail investors—would be justified in assuming that other investors like himself are rushing headlong with their money into funds. However, if you look at them like that, then these numbers are an illusion. Earlier this year, I had written that there are in reality, two distinct mutual fund industries in India. This distinction has become even sharper and is something that investors, as well as every other stakeholder needs to recognise. There’s a wholesale debt fund industry, and there’s the retail equity industry. Obviously, there are overlaps—some retail money is certainly in debt and a little bit of corporate money may be in equity—but broadly, this is the way the fund industry is bifurcated.

Because of a combination of factors, the wholesale debt industry is combing along quite well. Five years ago, this was about Rs 1.15 crore in size (average during 2004). From there to Rs 5.9 lakh crore now (the size of the debt part), it represents a growth rate of about 40 per cent a year. However, the retail equity money is another story altogether. By a simple count, the growth in the quantity of retail equity money managed by funds is not bad. From about Rs 25,000 crore in 2004, this has grown to Rs 1.9 lakh crore now. This is about 7.5 times in five years, or an impressive growth rate of about 50 per cent per year. But this number hides more than it reveals. During this period, the market has grown to about 3.5 times of what it was. If we take the growth of the Sensex as a floor level, then retail equity assets managed by the fund industry have grown to about 2.4 times in five years. That may sound impressive, but compared to the rah-rah generated by the Rs 8 lakh crore noise, it’s nothing much.

Moreover, when I look at how money has flowed in and out in relation to the rise and fall of the stock markets, the reason is not hard to figure out. When the markets fall, money funds’ assets fall, but not by as much as the markets fall. This means that some investors redeem their money to some extent. However, when the markets rise again, funds, assets rise but they rise a lot less than the markets rise. This is likely to indicate that it is during this phase that investors rush to redeem their money.

Consider the numbers: total equity fund assets hit a low of 1.09 lakh crore in February 2009. From that time to May 2009, assets went up to 1.44 lakh crore. However, had assets kept pace with the markets, they should actually have grown to about 1.8 lakh crore. This missing Rs 36,000 crore was what was redeemed by investors just when stocks started doing well. Some of this could also be explained by funds’ underperforming the indices but a large chunk of it is redemptions. This points to a pattern of investor behaviour that indicates why the retail equity fund industry has grown so sluggishly in real terms. Investors rush in when the markets rise, hang around when they fall, and then rush out when they recover their losses.

My hunch is that this is not unique to mutual funds. Retail equity investors are also caught in this kind of a cycle. At the end of the day, the curious dichotomy of India’s mutual fund industry is a by-product of the equity investing culture in India. As individuals, you and I can’t do anything about this, but as knowledgable and aware investors, we can probably try and avoid this behavioural trap.