Kotak's note finds narrative-focused NFOs led to ‘price-insensitive’ bids, unreal valuations

Net SIP flows have sputtered over the past few months, but NFOs have become an increasingly large proportion of overall inflows.

A Kotak Institutional note has underlined a series of 'short-lived, narrative-driven' stock themes in the market in recent years - PSUs, defence, railways, or capex plays to name a few - that have sustained fresh inflows and higher returns. Money in these ideas has jumped from one narrative to another, helping the stock market scale fresh highs and offer investors higher returns, the note has said.

In its note to investors, Kotak Institutional mentions how narratives have tried to capture the market's attention. "We note that narrative-driven valuation re-rating has been the primary driver of returns over the past 12-18 months. However, a few narratives of the past few months such as ‘400+ seats for NDA’, consumption or rural boost in the budget, increase in capex allocations, especially in defense, railways, roads, and privatization of PSUs have failed to materialize."

The Kotak Institutional note has observed a rise in thematic NFOs by mutual funds, focused on a particular sector, in order to attract greater flows. This forced deployment of NFO collections irrespective of price and underlying valuations has resulted in ‘price-insensitive’ bidding for stocks, taking them to unrealistic levels in several such ‘narrative’ sectors, Kotak said.

Between May and July this year, sectoral or thematic funds have accounted for nearly half of
the Rs 1.12 lakh crore raised by domestic mutual funds.

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Since the COVID-19 lows in 2020, domestic mutual funds have recorded a sharp expansion in unique investors, folios and flows. However, the retail money into MFs appear to be ‘chasing’ market movements, the Kotak note observed.  Retail inflows into domestic MFs have moved from flexi-cap funds in CY22 to mid- and small-cap funds in CY23, and finally to thematic funds in the first seven months of 2024.

Though the net SIP flow has sputtered in recent months, NFOs are increasingly contributing to a large proportion of overall flows into domestic MFs this year. "As a result, AUMs of sectoral funds/thematic funds are now larger than AUMs of most other fund categories," said Kotak.

Thin liquidity in several of these 'narrative-driven' stocks has resulted in exaggerated trades, the Kotak note finds. The sustainability of these flows and the subsequent returns may depend on a circular loop of trailing returns in thematic funds and continued inflows into them.

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