Experts peddle myths and misconceptions to downplay fears of FIIs pulling out  

October 20, 2010

Ask a question about how much the Indian market is dependent on FII investment and fund managers will flood you with myths and wishful thinking

Indian markets almost hit their all-time high in October, primarily led by the copious inflows from foreign institutional investors (FIIs). FII investment has already crossed $21 billion in 2010. However, this begs the question, if we are so dependent on the kindness of foreigners for our bull market, what happens when they start selling? To discuss this, Indian Merchants' Chamber of Commerce recently organised a discussion, in which Sanjay Sinha, CEO, L&T Mutual Fund, participated.

Commenting on this phenomenal rise in stock markets, Mr Sinha said, "The ongoing interest in equities is shown by strong inflow in the general emerging markets (GEM) which has been more than $40 billion, rising equity weights in GEM pension fund assets, heavy IPO activity and secondary issuance."

But aren't these factors clear signals of an overheated market? The flurry of IPOs, for instance, is a telltale sign of a market that has reached a kind of euphoria. Mr Sinha cited the example of the Korean stock market, which continued its upward surge despite FIIs pulling out funds from the market.

"Despite outflow of funds by FIIs from the Kospi Index, the Korean stock market was surging due to high participation from retail, mutual fund, insurance schemes and pension funds. So even if FIIs withdraw their funds from the Indian stock market, it should not plunge and retailers should show massive interest in the surging economic market."

Mr Sinha's facts may be correct but are quite irrelevant. Indeed, the facts in India are exactly the opposite. Where are the retail investors, mutual funds, insurance companies and pension funds in India? Here are some facts that Mr Sinha knows better than us but prefers to put out a different point of view to the public. Thanks to a slew of regulatory changes in the financial services industry, the number of retail investors is dwindling rapidly. Mutual funds have witnessed a massive hemorrhage of funds ever since the Securities and Exchange Board of India (SEBI) abolished the entry load in August last year.

September 2010 saw equity fund outflows touching a level as high as Rs7,100 crore, taking the outflow to Rs21,000 crore over the last 14 months. Similarly, revised Unit-linked Insurance Plan (ULIP) regulations have hurt the life insurance industry, whose ULIP sales accounted for 80% of the total. Pension funds do not even participate in the Indian equity markets in any meaningful manner. The Indian situation is exactly the opposite of that in Korea.

Mr Sinha had another piece of logic as to why the market will not fall with FII selling that completely contradicted the facts. He said that FIIs are unlikely to sell since it would erode the value of their investments! If that was true, markets would fall because all equity markets in the world are substantially dominated by institutions. The fact is, and Mr Sinha knows it very well, institutions move in herds. They buy in herds and sell in herds because of two reasons. One, institutional investors do not work in isolation. They are keen to know what their peers are buying and selling and even try to follow each other. FIIs are more interested in the short-term actions of their fellow investors than the long-term returns of their holding. Those who have increased their investment heavily recently are especially nervous of a decline. A temporary but large looming global or local crisis can send stocks skidding. Didn't the Sensex drop by 5,000 points in the April-May period on FIIs worrying about what is happening in Greece of all places? Two, when the market declines quite a bit, investors tend to withdraw their money and a serial redemption will force FIIs to sell together even if they don't want to.

They have no choice. Mr Sinha surely knows such a thing as selling caused by redemption pressure.

If Mr Sinha, an ace fund manager, peddled lots of misconceptions and myths about the institutional investors, another top fund manager, Sunil Singhania of Reliance Mutual fund, was not far behind. He argued that India is expected to be the third largest economy in the world. He feels that BRIC countries will double in size in 5-10 years from $8 trillion economy to $16 trillion while by that time the US economy will struggle. Hence he firmly believes that money will shift from developed economies to emerging ones. Even if you don't dispute these figures, beware of drawing any market-linked conclusions from it. It is classical fallacy to assume that economic growth and stock market movement are anything but loosely correlated. Ask yourself why does the fastest growing economy in the world not have the fastest-rising stock market? Shanghai is not among the best performing markets of the past 20 years.

Argues Mr Sinha, "Global economies especially developed economies like the US and the eurozone are giving mixed signals and pointing towards a prolonged period of benign growth which will keep the central bankers inclined towards maintaining (a) loose monetary policy stance." Well, this is the actual truth. A low interest rate regime in the West and Japan is what is giving an unusual lift to stocks in emerging markets, as also commodities. The bulk of FII money is chasing Indian stocks because of lack of alternatives and not because of the great long-term story of India. Watch out for a change in the interest rate situation in the West; a lot of money would return home and a small bout of selling by FIIs is all that is needed to bring the market down. The same fund managers who are saying FII selling doesn't matter or won't happen may be the first ones to sell.— Moneylife Digital Team