In the second part of a three-part series on how foreign portfolio investment is driving the Sensex, Janaki Krishnan and Rakesh P Sharma look at the FIIs' impact on the markets
Part I: Hedge funds key to further bull run
If foreign institutional investors have a larger-than-life presence on the bourses, there's a good reason for it. And it's not just because of the size of their investment kitty. In day-to-day trading, the FII effect gets amplified because all their trades have to result in delivery.
In April, when the market was groping in the dark for direction, FII trades accounted for about a fifteenth of NSE delivery volumes -- around 6.6 per cent. This figure rose to 20.83 per cent in June. After a brief decline to 11.39 per cent in August, the figure has now soared to 35.58 per cent. That means more than one in three "real" trades is influenced by FII money.
The absolute numbers also tell the same story. In terms of gross trading volumes -- a combination of sales and purchase -- FII volumes have risen from Rs 9,842 crore (Rs 98.42 billion) in April to Rs 19,066 crore (Rs 190.66 billion) in September.
The FII turnover in terms of the number of shares traded as a percentage of market turnover has gone up less spectacularly, from 15.57 per cent in August to 18.37 per cent in October. Not surprising, since FIIs tend to pile into large-cap shares, where values are higher.
One group that has made the most of the FII presence is the domestic mutual fund industry. They are often sellers when the FIIs buy big. On October 21, for instance, while the FIIs were net buyers of the order of Rs 286 crore (Rs 2.86 billion), domestic fund houses were net sellers to the tune of Rs 172 crore (Rs 1.72 billion).
So far in the current month, while the FIIs have been net buyers of equity worth Rs 5,385 crore (Rs 53.85 billion), the MFs have sold shares worth Rs 376 crore (Rs 3.76 billion).
Arindam Ghosh, country head of First India Asset Management Pvt Ltd, says this is part of a cautious strategy adopted by fund houses whenever the market seems overheated.
According to V V L N Sastry of FirstCall Equity Advisors, the main positive effect of FII inflows has been that it has provided a buyer for domestic mutual funds, helping their net asset values soar. Domestic financial institutions such as LIC and GIC and its subsidiaries have also cashed in on the boom in the market.
The second positive spin-off from FII inflows is that they improve the brokerage incomes of capital market intermediaries.
But the most important psychologically beneficial effect has been on the retail investor, who has been stuck with a stagnant market for more than two years now. As Maruti's post-IPO share performance shows, they now have a real chance to sell at a profit.
There is a downside to the FII dominance, of course. One is the crowding out of Indian investors. Given the size and scale of FII holdings, there's very little available for other investors.
If one were to look at the 10 Indian stocks that are in the Morgan Stanley index, the FII share of free float is 69 per cent. In the BSE Sensex, FIIs are sitting on 45 per cent of the free float. Take the top 100 traded stocks, and the FII pre-emption is 40 per cent.
When such large holdings are cornered by 800-lb gorillas, it's a recipe for increased market volatility. Any hint of FII purchases or sales gets magnified in terms of prices.
Intra-day share price volatility--the gap between a share's high and low during any trading day as a percentage of the day's opening price--has more or less doubled. The figure has risen from 1.13 per cent in May to 2.17 per cent in September. In October, the figure is around 1.90 per cent.
The unstated fear is simple: what happens if the FIIs decided to pack their bags one fine day and shift money elsewhere? According to the head of a foreign mutual fund, which also has an FII arm, foreign institutions should not be viewed as a single category. There is no reason why they should all exit at the same time. However, no one can guarantee that.
According to Sastry, the FIIs have no alternative but to stay invested for long in the Indian markets if they are to get returns on their investment.
This, of course, is a recognition of the fact that there are no obvious buyers on the scale the FIIs have operated so far in this bull rally. Without large inflows into domestic mutual funds and the entry of pension funds with longer investment horizons, the FIIs can only trade with one another in the short term without tanking the market.
Market circles say any selloff by FIIs can happen only gradually. For the near term though, the FIIs show no signs of withdrawal. Ghosh of First India Asset Management says that one can expect small profit-booking till the end of November after which the FIIs will again be back full throttle in the markets.
The jury is out on whether FIIs are bringing in the retail investor or crowding him out of it.