Why investors are favouring small-caps as mutual fund inflows fall 15% in July

By: Team India Tracker

Equities have rebounded from their March lows, led by mid- and small-cap stocks while large-caps lagged. The flows suggest investors are following performance but also remain willing to bet on smaller companies despite their lofty valuations

India’s mutual fund investors are becoming more selective. Net inflows into equity mutual fund schemes fell 15 per cent month-on-month to Rs 24,697 crore in July, but money continued to pour into small- and mid-cap funds, suggesting that investors remain willing to take higher risks in search of stronger returns.

Small-cap funds attracted a record Rs 7,768 crore in July, up 39 per cent from June. Mid-cap funds received Rs 6,192 crore, taking their combined inflows to Rs 13,437 crore. That was equivalent to 54 per cent of total net equity inflows during the month.

The contrast is striking. Large-cap funds recorded a net outflow of Rs 1,322 crore, while all other equity categories, except multi-cap funds, saw their inflows decline.

The shift is not difficult to explain. Indian equities recovered after hitting a low in March, with mid- and small-cap stocks leading the rebound while large-cap shares lagged. Investors appear to be following performance, but the flows also indicate that many are still confident about the longer-term prospects of smaller companies despite their relatively high valuations.

The trend matters because it shows that domestic investors have not simply become more cautious in a volatile market. Instead, they are changing where they take risk. Rather than abandoning equities, they are concentrating fresh money in segments perceived to have greater growth potential.

That confidence comes with a warning. Small- and mid-cap stocks tend to be more vulnerable when market sentiment turns. Strong recent performance can attract investors precisely when valuations are becoming stretched. The record inflows therefore reflect both confidence and a growing appetite for risk.

The broader equity-fund numbers were weaker because redemptions rose sharply. Gross inflows increased 3 per cent in July from June, but redemptions jumped 16 per cent. This pushed down net inflows even though investors continued to put substantial amounts of fresh money into mutual funds.

Flexi-cap funds remained another major destination, attracting Rs 4,709 crore in July. The category has consistently collected large amounts over the past two years and crossed Rs 6 lakh crore in assets under management for the first time last month.

Systematic investment plan flows also remained resilient. Gross SIP inflows rose marginally to Rs 31,961 crore, providing a relatively stable source of money for equity markets.

The July market backdrop was supportive. The Nifty and Sensex gained around 2 per cent during the month, helped by corporate earnings, softer oil prices and renewed foreign investor buying. Rising markets may therefore have reinforced investors' preference for the segments that had already performed strongly.

The debt market told a different story. Debt-oriented mutual funds attracted a net Rs 1.87 lakh crore in July after suffering a massive Rs 1 lakh crore outflow in June. The reversal was driven mainly by liquid and overnight funds, which typically see large withdrawals at the end of a quarter as institutions raise cash for advance-tax payments and balance-sheet requirements. Such money generally returns in the following month.

The recovery in debt funds, combined with equity flows and market gains, pushed the mutual fund industry’s assets under management to a record Rs 85.76 lakh crore in July, up 4.3 per cent from June. The increase was supported by higher market valuations and continued buying by domestic institutional investors.

The July numbers therefore reveal two different forces at work. At the headline level, equity mutual fund inflows weakened. Beneath that, however, investors continued to deploy money into riskier parts of the equity market.

That distinction is important for the broader economy. India’s household savings are increasingly being channelled into financial markets, giving companies and markets a deeper pool of domestic capital. But the concentration of new equity money in small- and mid-cap funds also means that household portfolios are becoming more exposed to market volatility.

For now, investors appear comfortable with that trade-off. The record Rs 13,437 crore flowing into small- and mid-cap funds suggests that the search for growth remains stronger than the fear of risk.

The question is whether that confidence will survive if earnings fail to catch up with valuations. July’s flows show where investors want to be. The next few months will show whether those bets were based on durable growth or simply the momentum of a market recovery.