FIIs in Indian equity markets

Debashis Basu points to some very interesting data about how FIIs recurrently get it so wrong with their Indian equity market investments.

From the bottom of 15,183 in mid-June 2022, the benchmark market index Nifty has soared 69 per cent to hit 25,791. In the past 18 months alone, the index has surged 52 per cent... Between June 2022 and September 20, 2024, FIIs were massive net sellers during a big bull market... They recorded net sales of Rs 1.82 trillion, the biggest monthly sales coming in June 2022, exactly at the bottom of the short, depressed period between November 2021 and June 2022. Even at those low valuations, panic sales by FIIs — of over Rs 58,000 crore in June 2022 — remain unsurpassed... Who did the FIIs sell to in the dark days of June 2022? To DIIs, who were huge buyers of almost Rs 47,000 crore that month, at what turned out to be the market bottom. This trend was repeated with boring regularity. Take, for instance, January last year, when the Hindenburg allegations against the Adani group shook the market. The mini-crash was an opportunity for DIIs to buy (over Rs 33,000 crore) while panic-stricken FIIs sold shares worth over Rs 41,000 crore... FIIs collectively took surprisingly poor calls at almost all major market turns. While they did invest strongly between May and July last year, the earliest stage of the ongoing bull market, they quickly turned bearish over the next three months, pressing net sales of Rs 76,000 crore, which were lapped up by DIIs (net purchases over Rs 70,000 crore). And so, when the market took off in mid-November 2023, it was DIIs who gained handsomely, with FIIs looking rather foolish.

Undeterred by the experience, FIIs remained net sellers every month between January and May this year barring March, when they had a timid net purchase of only Rs 3,300 crore. In the pre-election months, they sold over Rs 1.26 trillion, while DIIs made net purchases of over Rs 2 trillion. That call went wrong again for FIIs... Surprisingly, even in the past four months, after the election, FIIs only made a small amount of net purchases and pressed over Rs 20,000 crore of net sales in August. However, they have been net buyers so far in September. While these figures may be influenced in a small way by large bulk deals, where one side of the transaction is not an FII or DII, the trend is unmistakable. Over the last 29 months of a strong bull market, DIIs were net buyers of over Rs 5.91 trillion and FIIs were net sellers of over Rs 1.82 trillion.

And such trends of herding, sudden stops and capital flights have been historical features of FII investing in India.

In a bull market, they chase the flavour of the day and act like retail investors. In 1994, they had loaded up on the global issues of asset-heavy, poorly governed Indian companies. In the bull market of 1999, they frantically charged into shady software companies, either based on imitation or rumours or joint positions with speculators/another fund, or in expectation of a price runup before overseas equity floats. The flight to irrationality, reminiscent of 1993-95, led them to create an exposure of 60-80 per cent in technology, media, and telecom companies at huge valuations. In the crazy bull market of 2005-08, they were over-committed to real estate and infrastructure companies, earning poor returns on capital.

Two observations here. 

1. Sudden stops and flight to safety during market downturns are characteristic features of foreign portfolio investors worldwide historically and developing markets are especially vulnerable to such trends. India is only one more data point reinforcing this reality. Contrary to economic orthodoxy, there’s so much evidence today that macroeconomic fundamentals cannot be insurance against such reversals. 

As Basu writes, this raises questions about the perception of FIIs being objective and competent professionals informed by deep research and due diligence. In reality, no matter what drives the downturn or even the likelihood of its immediate reversal, algorithmic triggers get activated among the managers of the large international fund allocators that mandate such reversals. Once a flight becomes evident, the herd takes over and amplifies the flight. 

As we have seen with VC investments globally, public market investment allocation decisions of foreign institutional investors are generally driven by momentum and herd. Therefore, we should not be surprised by such herding in either direction. 

2. The sudden capital flight at downturns is a note of caution against capital account liberalisation. India has managed to stave off the perils of the capital flight due to domestic investors. In recent years have been associated with the arrival of a new generation of domestic retail investors, and DIIs too appear to have become discerning enough to spot opportunities and stay invested. So India could avoid the market destabilisation effects of such sudden large-scale withdrawals by FIIs. Will the domestic trends of capital inflows continue to remain robust during future episodes of capital flights?  

Indian government bonds were recently included in the JP Morgan Emerging Markets Bond Index, which means that foreign ownership of Indian T-Bonds could rise from the current 2% to 10% and more by next year. This creates vulnerabilities for government borrowings and macroeconomic stability. Will retail investors and DIIs to provide the backstop and buy the inevitable sales by FIIs? Or will the government be forced to become the buyer of last resort by nudging publicly owned institutional investors and banks to step in to backstop the G-bond markets?