This year has been tough for the India bulls. India is the worst performing market in Asia — also the only one, besides Indonesia, which is actually in negative territory. Unfortunately, this period of underperformance coincides with foreign institutional investors (FIIs) having the highest relative allocations to India in their history.
As I have discussed before, everyone is overweight India. According to data presented by Goldman Sachs, the typical emerging market (EM) fund is about 475 basis points overweight India (on an MSCI India benchmark weight of 7.5 per cent). According to the same data, the next two biggest overweight countries are Thailand and Brazil, at only 100 basis points each. This gives you some idea of the extent and consensus nature of the India overweight among fund managers. The typical EM fund has 4.75 times the overweight in India as compared with its next biggest relative bet!
The two countries in the EM world where fund managers have the maximum underweights are in Korea (757 basis points below benchmark) and China (320 basis points below benchmark). Unfortunately, these are the exact two countries with the best performance in the region year to date!
This positioning is causing intense performance pressure. Many friends running regional or global EM mandates have been complaining that they have never had a worse quarter of relative performance in their entire career. Many funds are already underperforming their benchmarks by 450-500 basis points — and that, too, in just a short span of four months.
Such a quantum of underperformance can have severe consequences for professional careers. The obvious implication of this underperformance is that most fund managers are under intense pressure from their management/business development people or risk department to reduce their holdings in India and increase these in China/Korea. Thus, price momentum will just reinforce itself in a cycle. The better performing markets will get inflows and the dogs will see money moving out. India benefited from this dynamic on the way up when we were outperforming, but will now face the brunt of this cycle going into reverse gear.
Thus, one should be prepared for an extended period of selling by EM and regional funds. The month of April saw negative FII flows in equities, and I think this is just the beginning. There is a possible counterweight to this if global funds (non-EM) were to pick up the slack and increase their India weights. This is possible; but it will take time, as these funds wait to see more tangible signs of reforms and on-the-ground economic improvement.
So just how vulnerable is India – and are our equity markets – to this anticipated country rotation?
The fact remains that at approximately $350 billion, FII holdings remain near all-time highs and account for about 40-45 per cent of the market free-float. FIIs have pumped in about $120 billion (at cost) since 2009-10, or about $20 billion a year. During this same period, the domestic institutions (insurance and mutual funds) actually sold equities worth $25 billion, so the FIIs were truly the only game in town.
Now, even a five per cent reduction in holdings implies foreign selling of $17.5 billion (almost equal to the annual inflows over 2009-15). While this number seems high, it is very much in the realm of the possible.
Sceptics argue that India has never seen FII outflows except in 2008-09 (outflow of $10.4 billion), which was in any case linked to the global financial crisis. That may be true — but India has never been as big an overweight.
Also, no market in the EM world has only inflows. With large inflows will also come years of outflows. We have to get used to this movement of capital as we become a more mainstream market.
It has taken two to three years to build this huge overweight position in India, it will not get corrected overnight. We should expect any unwind of the over-ownership to take at the minimum a few months. I think domestic market observers will be surprised by the quantum and duration of FII selling.
The obvious offset to this FII selling will be the re-emergence of the domestic institutional investor (DII). Investors forget that in 2006-09, DIIs invested more than FIIs every single year — cumulatively, $37 billion compared with $8.5 billion for FIIs. Therefore, it is incorrect to assume that the domestic investor is forever and always condemned to play second fiddle to the global players.
It is also a fact that the tide has already turned as far as the mutual fund industry is concerned. After selling almost $15 billion of equities between 2009 and 2014, mutual funds invested $6.6 billion in 2014-15, their highest total ever. Friends in the industry are also very confident of this figure rising dramatically in the current financial year, with the industry currently clocking inflows of a billion dollars a month. With alternatives like gold and real estate in stress, equity as an asset class seems to be making a comeback in the domestic investor’s asset allocation.
The domestic insurance industry is also poised to recover. Insurance companies sold almost $25 billion between 2011 and 2015, including $10.3 billion in 2014-15 alone. Thus, they were still selling all through the last financial year, even when the mutual funds had turned buyers. The tide is now turning even for the insurance companies, as they seem to be over the hump in flushing out policies sold in the heydays of 2007 and 2008. One can expect significant equity buying from the insurance sector going forward.
And the recent efforts by the government to allow the provident fund organisation to buy equities is another step in strengthening the buying power of domestic institutions.
Yes, FIIs will sell and reduce their holdings in India. It is bound to happen, given the extent and pervasiveness of their overweight on the country and their performance pressures. This selling will be an overhang on the market and probably cause India to continue to underperform its regional peers in the short term. However, we now can see the emergence of a robust and growing DII base that can offset the selling to a large extent. Thus, India may correct for some time, we may see some more downside in absolute terms, but this is unlikely to turn into a bloodbath. Annual inflows of $15-20 billion from the domestic investor, which I think are very possible, would ensure this.
Market leadership is moving from the FII to the DII. This is a good thing, to be celebrated, not feared — and it is about time. No economy or market of our size can or should move to the whims and fancies of foreign capital forever.
The writer is at Amansa Capital. These views are his own
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
