Impact of demonetization on Mutual Funds

On Nov 8, 2016, the Indian government declared that all the 500 and 1000 rs notes will cease to be legal tender from next day. The bold step, meant to remove the fake currency and clean up the black money, had many expected and unexpected effects on the overall economy. These economical developments can be observed to predict the impact of demonetization on mutual funds in India.

  • Banks got 11.5  lakh crore deposited within 4 weeks.
  • Most of the banks reduced FD interest rates by 25-50 basis points
  • Overall liquidity got reduced by 7.5 lakh crore
  • Retailers who were accepting the old currency saw a surge in sales whereas the ones who are not accepting saw a sharp decline
  • Business activity across country slowed down

What is expected to happen as a result –

  • Interest rates are expected to lower down by 1-2% in next 3-12 months
  • Inflation is expected to go down by almost 2% in next 1 year
  • Growth rate is expected to go down to 5-6% from current ~7.5%

The impact of demonetization on the overall economy is well summarized here. At a sector level, the demonetization impact is expected to be

Negative impact of demonetization

  • Housing-dependent sectors – Traditionally Indians buy-sell real estate with two kinds of money – 1. white that is declared and is according to the government approved rates and 2. black – that is undeclared and is paid in cash. Due to demonetization, the black or cash economy has taken a hard hit. Therefore it’s expected that the real estate buy-sell, construction, furnishing etc sectors will see a slowdown.
  • NBFCs – The demonetization has resulted in the removal of cash in hand and a drastic reduction in cash transactions. This may result in the bad quality assets for the finance companies.  They may see more defaults than usual because of the incapability of borrowers.
  • Jewelry – Majority of jewelry and other luxury products are bought in cash in India. As a result of demonetization, the cash in hand has wiped out temporarily. Therefore it’s expected that such sectors will see a downward sales numbers for next few quarters.

Positive impact of demonetization

  • IT – Demonetization impact on IT may not be as direct as other sectors. But there are two factors that may result in positive results for this sector. First, these companies are likely to get more clients because now businesses in India would have to adopt key transaction related technologies. Second, most of the IT companies (TCS, HCL, Infosys etc.) do a lot of exports. Due to the demonetization, it’s expected to have a lower yield (interest rates) in India. As a result, most of the institutes will take out the money and invest in USD. Hence the USD will appreciate further. We have already observed this trend in past 3 weeks. USD appreciation is a good news for the export-dominant sectors.
  • Banking – While people are managing their cash in every unique way, banks are seeing a lot more new accounts being opened and tons of money coming in. Although the loan rates are expected to go down, but NIM is going to remain same for the banks. With more customers and money, Banks are in good situation.

Demonetization impact on mutual funds

Let’s see how demonetization is likely to impact the growth of the various categories of Mutual Funds.

Large Cap Funds

Portfolio – invests in a diversified basket of equity stocks of companies whose market capitalization is at least equal to or more than the least market capitalized stock of BSE 100 Index.

Expected impact: Slightly Negative in short term, but positive in long term

Since the growth rate is expected to come down for next 1-2 years, this would reflect in the overall performance of Large Cap stocks. In long term, the demonetization impact on India growth story is very positive.

Top mutual fund in this category

SBI Bluechip Fund 

The top composition of the fund is in Financial (23%), Auto (11%), Healthcare (10%) and Energy (9%). This fund has given ~ 20% whereas S&P BSE 100 has given ~10%.

Multicap Equity Funds

Portfolio- The fund invests 50-90 percent in large-cap stocks, 10-40 per cent in mid-cap stocks and up to 10 percent in small-cap stocks

Expected impact: Slightly Negative in short term, positive in long term

Multicap funds are expected to be very volatile in short term. People are going to be uncertain of what is the expected growth and therefore they will react to every event – budget, GST, interest rate change etc.
In long-term, it is expected to give good returns. People will start preferring equity investment (mutual funds or direct) more than other traditional – real estate, gold etc.

Top mutual fund in this category

SBI Magnum MultiCap

The fund has generated ~ 39% return in past 3 years.
Top 3 sector holding of this scheme are Financial (~30%), energy (~12%) and automobile (~11%)

SmallCap and MicroCap Funds

Portfolio – fund invests in equity of the companies which are not part of the top 100 stocks by market capitalization and market capitalization of at least Rs.100 Crores

Expected impact: Negative in short term and positive in long term

These are most volatile mutual funds. In short term, due to the uncertainty and lack of disposable cash, they are expected to perform badly. But in long term, a well managed small cap fund can outperform a large cap or multi-cap by aptly selecting the sectors.

Top mutual fund in this category

Mirae Asset Emerging Bluechip Fund

Relatively new and small fund (launched in 2010, 3K Cr AUM), it has outperformed other funds in this category in the past 3-5 years. The fund has generated around 41% return in past 3 years. The top composition of the fund is in Financial (21%), Services(10%), Energy (10%) and Chemicals (8%)

Long Term Debt Funds

Portfolio- invests in a range of debt instruments and money market instruments to maintain the optimum balance of yield, safety, and liquidity.

Expected impact: Positive in short term and less positive in long term

Banks will get expected to receive  8-9 lac crore as surplus deposits. Even with a decline in loan rates, this amount of money is not going to get dispersed in next 1-2 years. As a result, every bank would buy bonds. This would result in high returns for the long term debt funds for a short term (~1 year). But in the long term, since the interest rates are expected to go down, the debt fund returns will go down too.

Top mutual fund in this category

ICICI Prudential Long Term Plan

With the safety of debt funds, this fund has given 13-14% returns in last 3 years. In the past 20 days, the fund has given more than 20% annualized returns. Average maturity is ~9.3 years whereas Yield to maturity is ~7.4%. Composition consists of ~ 57% is SOV and ~37% AAA.

Short Term Debt Funds

Portfolio -invests in debt and money market instruments with relatively low levels of interest rate risk

Expected impact: Positive in short term and less positive in long term

Similar to long term debt, short term debt (or liquid funds) are expected to give good returns in short term. Primarily because of the high demand for these instruments, from both banks and retailers. Banks are buying bonds to park excess inflows, whereas retailers are buying because they find short-term debt as the best options to park their money till the demonetization dust settles down and they have better investment avenues. In long term, however, the short-term debts are expected to give slightly lesser returns than today. Short term debt funds have given 8-10% returns in last 1-2 years. Once the interest rates are reduced, the expected returns on these funds would come to 7-9%.

Top mutual fund in this category

Birla Sun Life Treasury Optimizer Plan

This fund has performed consistently in past 3-5 years giving 10-12 % annualized. Average maturity is ~5 years whereas Yield to maturity is ~7.6%. Composition consists of ~ 40% is SOV and ~30% AAA.

Summary

Overall, the demonetization impact on mutual funds growth is expected to stay for 1-2 years. Beyond that, it’s expected to the transition of unorganized to organized among various sectors. Therefore, long-term investment decisions are not advised to be biased by such events. In short term, you can refer to the above discussion while choosing funds for investing.