Of Players and Spectators

The clout of FIIs is growing while Indian mutual funds sit it out. This does not augur well for markets.

It’s a bit like having the Indian Premier League cricket matches in South Africa. Over the past few months, the Indian equity market has been the playing field for foreign institutional investors (FIIs). They have been actively participating in the Indian market, which provides a happy, and relatively less bumpy, hunting ground for them compared to several other countries. That, of course, is no cause for complaint, since it is natural for FIIs to return to Indian markets, given that the India growth story is once again gaining momentum.

What is worrisome, however, is the manner in which Indian mutual funds (MFs)—the most important avenue for the retail investor to participate in stock markets—have behaved of late. While FIIs have been churning their holdings and increasing their share of the free float in the markets, recent data shows that MFs have, by and large, been passive spectators in market movements over the past few months.

A recent report by Citi shows that foreigners have raised their ownership in Indian companies to 17 per cent, from 16 per cent, and the pace of recent fund flows shows that this trend will increase. More importantly, the influence of foreigners in Indian markets is rising, since foreign capital (institutional and direct) now holds over half of the market’s free float. The value of FII holding now stands at a hefty $187 billion. This is, of course, lower than the September 2007 peak of $265 billion, but counter this with the dormant to negative domestic flows, and you get the picture. In fact, the report points out that total foreign ownership of the Sensex is at 25 per cent, on the lines of domestic institutional ownership. And that is considerable clout.

A Bank of America-Merrill Lynch report comes to similar conclusions about FII activity in the last quarter, pointing out that they were significant buyers of stocks and continued with their clear bias in favour of the financial sector.

Data points out that in the September quarter, mutual funds hardly made any purchases in the market, despite some money coming into equity funds. Clearly, domestic MFs have not had any part in the market rally in the last quarter. And during that period, the BSE Sensex rose from 14,500 levels to around 17,000.

Add to that the fact that in September and October, the equity funds saw net outflows of Rs 1,756 crore and Rs 2,123 crore respectively, and it is clear that it will be some time before MFs can be part of the market action.

The idea is not to sound jingoistic or argue for a more insular equity market. But the downside of this trend is that an FII-dominated market will be more susceptible to developments globally, as FIIs tend to react more intensely and swiftly to such events, rather than banking on the stability of the India growth story alone. A heterogenous market, with depth and a large number of players, is always more desirable for better price discovery than one where one set of players tends to dominate the action. Domestic institutions provide that much-desired equilibrium.

Though MFs have been investing in primary issuances and qualified institutional placements, with several investors preferring to cash out during the rally, the funds need to keep cash in hand to meet redemption requirements. So, participation in the secondary market had to be curtailed. Fund houses also argue that the Securities & Exchange Board of India (Sebi) move of banning MF entry loads has also taken a toll on inflows because distributor commissions have dried up, but detailed evidence of that is awaited.

The bright side to the story is that while MFs are sitting it out, domestic insurance companies have stepped in and together hold as much as 23 per cent more equity than MFs. Some private insurers hold substantially more equity than several MFs, and that is a good sign.

Mutual funds will have to bring in many more retail investors to participate in the Indian capital market. The more they are able to do so, the more depth they will provide to it.

But they will also have to be aggressive fund managers, seizing every opportunity that the market presents. Sitting on the sidelines and watching others play the game is not a great way of spreading the equity cult.

(These are the author’s personal views.)

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