Retail buys, but stake declines

Retail ownership of the BSE500 has fallen from 21 per cent in 2005 to 14 per cent now despite net buying

Retail participation in equity markets shot up in India last year, like in most countries. Retail share of trading jumped from around 50 per cent to about 70 per cent. It was widely expected to be temporary, driven by individuals who not only had forced savings (due to the lockdowns) to deploy in a low-bank-deposit-rate environment, but also had free time to trade, and benefited from the sharp rebound in markets in the second half. 

However, this explanation of the retail-trading surge was mistaken on at least the first count, as even after the economy has mostly opened up, trading activity remains elevated, and has, in fact, picked up. The number of dematerialised accounts is now 30 per cent higher than in January last year, as compared to the “normal” growth range of 10 per cent to 15 per cent pre-pandemic. It is now likely that direct retail participation in equities would stay elevated for a while.

What does this mean for the markets? Retail investors collectively held about 14 per cent of the BSE500 at the end of December 2020, almost unchanged from the level seen at the end of March, and the lowest in at least two decades, having fallen from 21 per cent in 2005. This decline is despite making net purchases during the period. How can retail share of holding decline despite buying more shares than they sold during the period? The reason is underperformance, that is, the collective stock portfolio of retail investors has gone up less than the BSE500 during this period. This relative performance has been volatile too: There was steep underperformance between 2005 and 2011, a catch-up between 2011 and 2018, but then their performance lagged again.

Why the underperformance? Note that this is before transaction costs, which is blamed by many researchers for hurting retail performance: Not only do individual investors pay higher transaction fees (this may have changed a bit), but also trade more frequently (they own 26 per cent of the BSE500 free-float, but account for 70 per cent of trading). There can be two broad reasons: Either poor market timing (measured at an index level), or poor stock selection. Nearly everyone knows someone who bought close to the market peak, and sold in panic close to the market bottom, like some characters in the movies of the 1950s losing their fortunes in the “satta bazaar”. While that may be true for some individuals, it is not visible in aggregate data: At least since 2005, total retail buying rose when markets plummeted, like in 2009, early 2011 and 2017.

That leaves only poor stock-selection as a reason, and indeed, data for prior periods confirms this view. Not only is their ownership of better-performing stocks lower than average, in all periods we studied, retail investors net bought very few of the shares that outperformed the BSE500. They either net sold the ones that did well, or bought those that did not. The list of stocks with market capitalisation greater than $5 billion dollars, where the retail share of ownership is at a record low, is a literal who’s who of blue-chip names that have consistently delivered strong returns over this period. Researchers over the past several decades have observed several disadvantages individual investors face in the market that drive underperformance, ranging from lack of information to biases like the disposition effect (selling winners and holding losers). These no doubt affect portfolio managers too, but perhaps less so. We focus on a few high-level factors.

One obvious axis of over/under-ownership is market capitalisation: Retail is more exposed to the small- and mid-cap stocks, and thus more affected by their relative performance. Retail holds 24 per cent of the outstanding shares of firms with market capitalisation less than $1 billion, but only 13 per cent of the larger stocks. The sub-1 billion stocks account for only around 10 per cent of the combined retail portfolio, but given the significant over-ownership, their relative performance has a bearing on portfolio returns. Institutional fund managers, particularly foreign ones, prefer stocks that they can buy and sell more easily, and over time have accumulated the larger market-cap stocks.

Given that retail owns 54 per cent of the free-float of small- and mid-caps, continuing retail inflows should help sustain the mid- and small-cap outperformance of the last six months at least in the short term.

Illustration: Binay Sinha

It helps to remember that trading of stocks is not segregated across market-cap thresholds. If foreign fund inflows see a surge, for example, given their predilection for the large-cap stocks, those may outperform in the short-term. However, a growing gap in valuations between them and small/mid-caps would open up an arbitrage that some retail investors can step in to close by selling large-caps and buying small/mid-caps. Similarly, the reverse may happen if meaningfully higher retail inflows sustain and the valuation gap between large and small-caps closes sharply.

For small/mid-cap outperformance to last, earnings need to revive. Whereas the profit pools of large-caps have strong global linkages, mid/small-caps are much more exposed to the domestic economy. As the Indian economy’s medium-term growth prospects are improving, these firms should find a conducive environment to grow their earnings. This should help retail portfolios.

Another axis is sectoral: Sector-weights in the portfolio for retail investors in aggregate are very different from that of institutional managers (as they must be, given that all types of shareholders cannot be over- or under-weight the same sectors; someone must be on the other side). Compared to institutional money, among the major sectors, the retail basket is underweight private banks, non-banking financial companies, IT services and energy, and overweight staples, industrials and consumer discretionary, among others. This dimension does not show any easy conclusions, and points to one of the challenges of portfolio construction: Right sector, but wrong stocks in the sector. 

The concept of over- and under-performance is a zero-sum game by definition. Of the three types of investors in listed firms — that is, promoters (either government or private sector), institutional money managers (either domestic or foreign) and retail— for one set of investors to outperform, another set must underperform. Promoters are by definition exposed to just one firm, so in many ways the game is between institutional and retail investors. If retail beats the benchmark, institutional investors would end up underperforming. Given that the reverse has been the norm thus far, institutional money may also see gains. The challenge for institutional money is of course to generate outperformance post-fees to beat their other competitor: ETFs.

The writer is co-head of APAC Strategy and India Strategist for Credit Suisse