Dalal Street's main indices have taken a breather after coming within little more than one percent of their all-time highs of October 2021. That when institutional investors — domestic and foreign alike — have have begun the New Year by withdrawing funds from Indian shares. Have Indian equity valuations impacted mutual funds' appetite for domestic shares, especially from the broader segments?

Geojit Financial Services' Chief Investment Strategist, VK Vijayakumar, is of the view that funds in India have indeed turned cautious on equities.

"There is a near consensus that valuations in India are stretched, and therefore vulnerable to sharp corrections... There is a concern that monetary tightening this year may lead to capital outflows particularly from emerging markets with premium valuations like India," he told CNBCTV18.com.

A number of foreign brokerages and even the RBI have flagged stretched Indian equity valuations.

Much of the rally in the market has been led by IT and healthcare stocks. Broader segments have continued to fare better than the headline indices in the past three months, a trend seen during much of the pandemic era.

IndexPast 3 months20212020
Nifty Midcap 100-0.446.121.9
Nifty Smallcap 1004.359.321.5
Nifty 500-0.630.216.7

Vijayakumar thinks that in the current context, safety is in high quality largecaps, and in sectors like IT, financials, specialty chemicals and construction. Broadly, he feels a churn is likely from the broader market to largecaps, and from growth to value.

Recently, Edelweiss Mutual Fund decided to limit inflows in its Recently Listed IPO Fund, restricting lump-sum investments or SIPs of more than Rs 1 lakh per day with effect from February 1. The move was in line with its investment strategy stated earlier. The scheme recently crossed the Rs 1,000 crore mark in assets under management (AUMs). The fund invests in recently-listed companies or businesses looking to tap the capital market through the IPO route.

In 2021, as many as 63 companies raising Rs 1.2 lakh crore through main-board IPOs, about 4.5 times more than the funds raised in the previous year.

Also, Motilal Oswal Mutual Fund temporarily stopped accepting lump-sum and switch-in investments in three of its international schemes: Motilal Oswal S&P500 Index, Motilal Oswal MSCI EAFE Top 100 Select Index and Motilal Oswal Nasdaq 100 Fund of Fund. The move was aimed at meeting certain regulatory requirements.

However, in the past, fund houses have often halted lump-sum inflows in their schemes in times of high valuations.

"Every fund has its capacity based on the present portfolio and its outlook on the market. It is important for MFs to follow this process," said Harshad Chetanwala, Co-Founder of MyWealthGrowth.com.

"Usually, the funds like to keep their portfolio reasonably liquid so that it does not take a major hit in case of any consolidation or volatility in the market. It is because lack of liquidity has a direct impact on the portfolio value of the fund, affecting its investors' returns," he explained.

Are MFs turning cautious on Indian equity valuations?

The kind of run-up midcap and smallcap segments have had over the last couple of years does warrant a cautious approach due to the valuations, said Chetanwala.

"Fund managers have been looking into it and would continue to keep a close eye on the valuations in future as well. However, it may not be correct to say that MFs are exiting these segments. Within both the segments, there are companies that still have potential to grow in the longer run," he said.

Mutual funds found favour among investors in 2021. The industry added a staggering Rs 7 lakh crore to their asset base during the year on the back of a rally in the equity market and a slew of major new fund offerings (NFOs).

The domestic MF industry's AUM increased 24 percent to a record Rs 38.5 lakh crore in the first 11 months of 2021, exceeding the Rs 31 lakh crore in 2020, according to data from the Association of Mutual Funds in India (AMFI).