Few topics are discussed as often in market commentary as the buying and selling of foreign institutional investors. Their decisions can swing daily closing levels and shape sentiment. Observers who track the Kospi Index often see similar flow patterns affecting emerging markets generally, since large funds allocate across many regions simultaneously. In India, the Sensex Index has at times fallen despite robust domestic news because overseas funds were reducing exposure. Yet in recent years, domestic participants have grown strong enough to cushion such pressures, changing the market’s character.
Table of Contents
Who Moves the Market
Foreign portfolio investors are institutional investors who manage funds on behalf of pension funds, endowments and asset managers. Their allocation decisions are based on returns versus other assets, expectations about currency movements, interest rates and risk. Since their portfolios are large, even a small change in the percentage of funds allocated to India translates into millions of rupees.
Domestic institutional investors comprise mutual funds, insurance companies and pension funds. In addition to these, there are also retail investors, both direct and through systematic investment plans. These investors have provided a steady inflow into the stock markets, which has only increased over time due to higher savings rates and a more formal economy.
The Rise of Domestic Liquidity
Mutual fund systematic investment plans have seen phenomenal growth in recent years, providing a steady inflow of money into the stock markets. This has helped cushion the effect of large-scale foreign selling since institutional investors have been buying up the shares dumped by foreigners. While it is true that flows still affect the markets, the impact is not as severe as it used to be, as domestic investors are now better able to offset the impact of foreign investors’ actions.
While such a scenario may cushion the impact, it is still true that flows are a function of many factors, and it is easy to get disappointed by short-term market movements.
What Causes Flows to Reverse?
There are several reasons why funds flow out of the country. One, rising interest rates overseas could make other assets more attractive, besides providing better returns. A stronger Dollar could also hurt the returns of foreign investors which in turn could lead to selling of shares to reduce exposure to the rupee. Political instability or financial stresses, for instance, could cause risk-averse investors to sell off their emerging market holdings.
At the domestic front, valuations could also play a part in causing funds to flow out. For instance, if earnings growth is lower than the valuation, many investors might decide to book profits and move their money elsewhere. Policy or tax changes could also cause a rethink on the part of investors. On the other hand, with higher growth and attractive valuations, it is only natural for funds to flow back into the country.
What Should an Individual Investor Do?
While the advice for individual investors is obvious, it is still worth reiterating. First, you should not get spooked by the news of large-scale foreign selling or buying. Second, you should focus on fundamentals. Strong fundamentals see investors return to the market soon after a sell-off caused by flows.
Third, take advantage of any corrections by buying in phases if you have an investable surplus. Fourth, ensure that you have a well-diversified portfolio so that you don’t face huge losses if some stocks fall sharply after foreign selling.
Keep an eye on the currency and bond yields as they are likely to move in tandem with the flows. A falling currency will benefit exporters while hurting importers, and this depends on what kind of stocks you hold.
A Longer-Term View
India’s growth story is being driven by a young population, rapid urbanisation, extensive infrastructure development, digitisation and a formalising economy. These trends have been the reason why many investors keep their money in the country despite any given short-term flows. It is important for individual investors to understand the importance of flows and utilise this information to their advantage.
Remember, while flows are useful to understand market psychology and help explain certain actions of the market, they are rarely a deciding factor in the long-term viability of a business. A well-managed company with attractive fundamentals will perform well in the long-term regardless of the short-term fluctuations. By taking a well-diversified approach and regularly investing in the stock market, you are likely to take advantage of the flows in the long-term. The increase in domestic liquidity is only a sign that the Indian economy is maturing and as an investor, you should take advantage of this by being an informed investor.
