When FIIs play Pied Piper

After I had interviewed one of India’s leading money managers on the market’s stratospheric rise, we got chatting. So was he happy that FIIs were so bullish on India even though domestic investors have been shunning mutual funds? After all, all his equity funds now sport impressive returns.

“Not really,” was his surprising answer. “You can never predict when these guys (FIIs) will turn bullish or even what stocks they will fancy. Once they’re in, you have no choice but to follow them, else you miss the bus.” The problem he articulated is shared by most Indian investors, both big and small, today.

While FIIs have been gung-ho about these elections since last September and have relentlessly poured money into Indian stocks, cynical domestic investors have simply watched from the sidelines. Now wondering if India is on the cusp of a new bull market, they aren’t sure what to do. Should they jump into stocks at Sensex 25000 after deeming it too risky at 15000? If they don’t, will they miss out on an opportunity to amass untold riches?

Well, that’s the price we Indian investors have to pay for turning over the domestic stock market, lock, stock and barrel, to FIIs. After their recent buying binge, FIIs tower over every other class of non-promoter shareholders in Indian companies. The value of FII holdings today stands at about ₹16 lakh crore. That is six times the value of shares held by the mutual fund industry and three-and-a-half times what the insurance industry owns. All the retail investors in India, put together, hold less than half of what FIIs own.

In fact, the level of FII ownership in the Indian market is at a new high, reckoned from the nineties. Shareholding patterns as of March 2014 show that FIIs held well over 40 per cent of all freely tradeable shares (excluding promoters) in the Indian market.

While this flash-flood of foreign money is no doubt good for India’s import-intensive, capital starved economy, it has its flip side.

To start with, rising foreign ownership seems to be weakening the already tenuous link between Sensex movements and the state of the economy. In theory, stock prices are supposed to derive their value from the profits of companies they represent and companies in turn are expected to mirror the health of the local economy.

But we have seen a very different scenario play out in India over the last two years, with dismal macroeconomic data and flat corporate profits failing to dampen the market’s animal spirits. Why, even last week, as the Sensex was hogging the headlines, the latest Index of Industrial Production showed that India’s annual industrial output shrank for the first time in three decades.

The disconnect between FII purchases of Indian stocks and their faltering fundamentals could be on account of two factors. For one, not all classes of FIIs are fundamental investors.

While pension funds or sovereign wealth funds may evaluate a country’s prospects when they make stock purchases, there’s a whole class of hedge funds, algo funds and high frequency investors out there who couldn’t care less about the economy. They’re in the game purely for short-term or even momentary gains.

Then, there is the fact that the Indian market is just a drop in the sea of options available to foreign investors. When large global funds choose to pump money into India, they factor in a lot besides the country’s political climate or GDP growth. US interest rates, the direction of the dollar and the euro, the fate of quantitative easing, prospects for competing markets such as China and Japan, are all factors that will matter, as much as Narendra Modi’s economic policies, to FIIs weighing their India allocations today.

Domestic fund managers may pore over balance sheets and construct all the mathematical models they like. But ultimately, the latest pronouncement from Janet Yellen or Mario Draghi holds as much power to sway Indian stock markets, as the latest quarterly results season.

The fluid composition of the FIIs makes their actions a wild card in the marketplace. For all the Indian market’s reliance on FIIs, there is a complete lack of information about who these foreign investors actually are.

So, are the FIIs who have poured $17 billion into India in the last nine months, hedge funds or pension funds? Are they passive index-tracking exchange traded funds? Or dare we hope that global sovereign wealth funds and pension funds have finally been converted to the India story?

The truth is that we don’t really know. As all efforts by Indian regulators to force FIIs to register here, subject them to more stringent KYC norms or curb investments via Participatory Notes have come to nought, we have very little official data about the identity of the ubiquitous foreign investors who play pied piper.

The final problem with mounting foreign ownership is that given their very different reasons for owning stocks, they may not share the governance concerns of domestic shareholders.

The new Companies Act relies heavily on a company’s non-promoter shareholders to vote out proposals that are inimical to minority investors. But the entities who control the most voting rights in India today, after the promoters, are the FIIs. As against the average FII stake of 20 per cent, domestic mutual funds and insurance companies together hold less than 10 per cent of the voting rights in Indian companies. Retail investors, never keen activists in any case, own about 8 per cent.

Now, even if they own a substantial chunk of a company’s stock, foreign investors may simply not bother to exercise their voting rights if they are in the game for quick profits. Where long-term FIIs are in the driving seat, their interests may diverge substantially from those of domestic shareholders.

All this shows that it is not just professional money managers who need to lose sleep over the rising clout of FIIs in the Indian market. Retail investors and Indian regulators have reason to worry too. As long as FIIs continue their headlong rush into Indian markets even as domestic investors stay away, it is the principles of fundamental investing and good governance in Indian companies that may be the casualty.