India is entering an equity saving ascent that is both cyclical and structural, as households shift out of physical assets and toward financial assets. In addition to favourable demographics for saving, this transition is being driven by positive real rates, improving equity returns, and better growth prospects.
Rise in equity savings
We expect equity saving to equate to 1.4% of GDP by FY2026 (double the current 0.7%), implying a cumulative equity saving expansion of $420 billion over the next decade. We expect a shift towards accumulating savings in financial assets, and, within that, equity saving, to be propelled by falling age dependency and low risk aversion (as is typical of a young population) on the demand side, combined with macro stability and initiatives to educate investors, as well as progressive regulations, on the supply side.
Role of mutual funds
The heavy lifting for this super liquidity cycle is likely to be borne by domestic mutual funds. We expect their flows to aggregate to $216 billion (Rs 14 trillion) in the coming decade, as compared to $45 billion over the past 10 years. The key driver here is a focus on systematic investment plans (SIP). Flows via SIPs have grown at a 33% CAGR over the past five years, and at a 50% CAGR over the trailing three years.
Mid- and small-cap stocks
History suggests mutual funds have had close to 40-50% of their equity allocation towards mid- and small-cap stocks. This strategy has worked and has helped them earn excess returns over the benchmark, reflecting the underlying performance of mid- and small-cap stocks. Since 2001, India’s mid- and small-cap indices have risen at respective CAGRs of 18% and 16%, while the narrower market (Nifty) has appreciated at a 13% CAGR.
Mid- and small caps will likely continue to outperform the market over the next 3-5 years. That said, the growing size of domestic mutual funds, both on an absolute basis as well as relative basis, will make it difficult for them to extract outperformance at the aggregate level by buying just mid-caps. The scale has already reached a point where making the right mega cap call will become crucial to differentiating performance. Our calculations show that domestic mutual fund assets could catapult to $ 1 trillion in the coming decade from $100 billion currently, underpinning the scale problem.
The coming domestic ETF boom
The other large source of domestic flows will likely be retirement funds. On a combined basis, we expect equity saving via these retirement funds to reach $170 billion by FY2026. Within the retirement saving pool, provident funds will drive the ETF boom. In FY15, the labour ministry for the first time mandated a minimum equity investment for its annual inflow for employee provident funds (EPF).
The initial equity allocation in FY16 was 5% of incremental flows, which was increased to 10% of incremental flows in FY2017. This flow is directed into equities via domestic ETFs. Over the past two years, the Employees’ Provident Fund Organisation (EPFO) has invested close to Rs 235 billion in equities via the ETF route. The labour ministry has increased the allocation to 15% for FY18. This could imply additional flows of Rs 300 billion into equities via ETFs.
The author is MD, Morgan Stanley India
Extracted from Morgan Stanley’s India Equity Strategy Report —India’s US$10 billion club and likely winners