When money goes into the wrong parts of the equity market, and when it flows in great excess to what those themes or sectors can absorb, we set ourselves up for prolonged pain. Yet, as our confidence stays high, we refuse to see what is coming.
Our money gets mechanically invested in the same places without a sense of urgency to create a portfolio reset. The year 2025 clearly saw the Indian domestic investors significantly misallocate capital within equities for this very reason. Money kept going into the wrong parts of equity through domestic mutual funds.
While the year saw positive flows into equity in every single month, the monies were predominantly invested into flexicap, mid cap, and smallcap funds. The flexicaps were the largest category in inflows and have seen divergent returns across funds based on their individual allocation mix. How fund managers deployed money within their flexibility decided how their risk taking played out. Those who predominantly owned larger companies from within the top 250 by valuation did well in the flexi cap space.
But, the problem seems to be building up in mid-cap and smallcap funds which received Rs.33,769 cr and Rs.34,962 cr so far in this financial year. Strangely,the dedicated large cap funds received the least funds (Rs.15,506 cr) out of the total equity flows of Rs.2,28,024 crores so far this year. This has clearly skewed the investing done by mutual funds, kept valuations artificially inflated in smallcaps and midcaps, even while creating a higher impact costs for mutual funds.
The market has turned more illiquid even though the mutual funds have received higher and stronger flows. This is the irony of this market. The reason for this situation is the way mutual funds are deploying capital through IPOs, QIPs, private placements and bulk deals. The trading volumes even in shares with higher valuations has been falling indicating that the liquidity in the market is drying up very fast. Our market can be tested very badly if there is any event that shakes up sentiment.
The margin trade financing {MTF} is also at a very inflated level, further exposing the domestic institutions to risk as the stocks owned by them are also seeing very high leveraging by the public. All these factors clearly confirm that the risks are rising in this market even as the valuations are in gradual decline.
If the market senses the rising risks and anticipates a crisis, then the MTF deleveraging alone can create a sharp cut in valuations of companies where there are a lot of leveraged trades running. While the Nifty50 looks stable and consistent in its performance during 2024 and 2025, the inconsistencies seen in the performance of microcap and smallcap indices in 2025 are a warning signal to domestic investors.
2026 will probably see further divergence within equities and investors must be well positioned to weather the volatility that will present itself next year. Investing needs to be far more specific, precise, and focused now.