Why do FIIs have such an inordinate impact on equity markets?

From the time FIIs were permitted into the Indian markets, they have continued to influence the direction of the Nifty and the Sensex in a meaningful way. In fact, FII buying and selling has almost become like a veritable barometer to judge the direction and trajectory of the equity markets. Intuitively, if you were to look at the rallies and market crashes in the last 15 years, they are typically accompanied by aggressive FII buying and selling respectively. Even over a much shorter period, that situation continues to hold. Let us understand this FII phenomenon by focusing on the last 1 year of FII data and correlate with the market movements.

How markets and FII flows correlated in fiscal year 2016-17…

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                                                                                Data Source: NSDL

In the above graphic, we have considered the FII net buying in equity and debt on a monthly basis from May 2016 to April 2017. We have ignored May data as partial data may distort the overall picture. The chart shows clearly 3 distinct phases. In the first phase that started post the Union Budget 2016, the FII buying came back in a big way and the Nifty actually rallied from a low of 6850 to a high of 8600, showing a high degree of correlation with the FII up-tick. Post October, the FII had expressed rising concerns over a possible rate hike by the US Fed and the relative attractiveness of the Indian markets.

Additionally, the demonetization driven in November 2016 also raised worries among FIIs about the impact of a possible liquidity crunch. Consistent FII selling post October 2016 took the Nifty to a level of 7900. However, post January 2017 there were hopes that Donald Trump’s aggressive reforms on the tax and infrastructure investment front will have a positive global spill-off. This brought back the FIIs into net buying mode leading to the Nifty touching an all-time high of 9500. If we consider the last 1 year data as representative of the trend, then there is a clear positive relationship between FII buying and the Nifty movement. In a nutshell, FIIs continue to be the key drivers of the Nifty and the Sensex.

Why are FIIs so important in the equity market scheme of things?

  • FIIs have a fairly large ownership of Indian stocks. If you were to look at the top 100 Indian stocks, FIIs have approximately 25% ownership of the equity. That is second only to the promoter groups which own nearly 49% of the equity of the top-100 companies. Since the promoter stake is normally not liquid, the FIIs constitute more than 50% of the free float in most companies. It is this control over free float that gives the FIIs so much decisive powers when it comes to the direction of the markets.
  • FIIs are normally executing orders on behalf of large institutional clients based out of the US and Europe. Such clients are typically institutions like index funds, Exchange Traded Funds (ETFs) and Sovereign Funds. These investors are macro investors and hence tend to move in and move out at the same time. Unlike the MFs, which normally do not behave in a herd fashion, the FIIs normally tend to behave in a herd fashion due to the similarity in the nature of their underlying clients. This contributes more to market movement.
  • FIIs, due to technical reasons, tend to rely more on large cap stocks and less on mid-cap stocks. This is in contrast to the MFs who focus more on searching for alpha in the mid-cap and small-cap stocks. Since most of these mid-caps cannot influence the index overall, the action of MFs is normally outside the Nifty and the Sensex. Thus despite strong flows from MFs, the impact on the index is not anything worthwhile.
  • Fourthly, the institutions that place orders through these FIIs are having tremendous economies of scale. If you look at some of the long-only funds like Fidelity and Oppenheimer or hedge funds like Blackrock or even index funds like Vanguard, their Assets under Management (AUM) is bigger than the market capitalization of the NSE. Hence they also become sentimental influencers of the retail and domestic institutional investors.
  • Lastly, there is a currency angle to FII trades. When FIIs invest, they also bring in dollars. That is why you will see that on the days when there is aggressive buying of FIIs, you will see the INR appreciating. The appreciation of the INR from 68.5/$ to 64.5/$ in a span of 4 months accentuates the impact of FII flows. Domestic flows, on the other hand, do not really impact the currency, which is why their impact is limited.

It needs to be remembered that domestic Mutual Funds have emerged as a potent force. During the FII selling between October 2016 and January 2017, the Nifty could have cracked sharply had it not been for the consistent inflows from the mutual funds. While the clout of mutual funds in the equity markets is surely growing, the key institutional influence for the time being continues to be that of the foreign institutional investors (FIIs).

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