The investment technology of FIIs and DIIs

Economic Times, 25 October 2013

Do foreign investors possess a valuable investment technology? In other words, do the firms that they pick perform in the future? Recent research suggests that this is not the case: the firms that are isolated by foreign investors in India underperform: on stock market returns and on operating performance. In contrast, the firms chosen by domestic institutional investors do well. This suggests that foreign investors would be better off doing passive management, and that policy makers need to do more to foster deep engagement in India by foreign investors.

An equity investor can always choose to buy index funds of various kinds. If he embarks on security selection, investment technology consists of the capacity to obtain information, analyse it, and identify firms that will do well in the future. In a paper The investment technology of foreign and domestic institutional investors in an emerging market, which appeared recently in the Journal of International Money and Finance, Ila Patnaik and I examine the investment technology of domestic and foreign investors in India.

A big idea in the field of international finance is the inadequate knowledge of a foreign investor in an emerging market. FIIs suffer from `home bias' (investing too little abroad) and may make poor investment decisions. Home bias consists of significant foreign investment being in only a small pool of Indian firms. It is natural to ask: How do the firms chosen by foreign investors fare, when compared against firms which ignored by FIIs and by DIIs?

A simple comparision would not be fair, as the firms chosen may be quite different from those not chosen. E.g. foreign investors favour high beta companies. In good times, high beta firms will outperform, so in good times it will appear that foreign investors have picked well.

Eugene Fama and Kenneth French have found that the three key features that shape portfolio returns are size (i.e. market capitalisation), beta and the price/book ratio. Hence, for each firm chosen by FIIs, we find a partner from among the companies shunned by institutional investors, matching in these three dimensions. This ensures an apples-to-apples comparison. This comparison will measure the security selection of FIIs after controlling for asset allocation.

The results are striking. Firms chosen by FIIs grow fixed assets by 23 percentage points (over and above the firms not chosen) in the following 3 years. But their output growth is only 16 percentage points better. Productivity worsens. The stock market returns are worse, over this three year horizon, by 12 percentage points.

What about firms chosen by DIIs? The identical methodology yields different results. These firms experience a decline in fixed assets and employment (when compared with similar firms that got neither FII nor DII). But there is sales growth. The chosen firms seem to be grappling with decline and succeeding in doing so. The stock market returns are superior: over a three year horizon these firms outperform by 18 percentage points.

This suggests that foreign investors operating in India face the same problems of international finance everywhere: they are far away and often make weak decisions. This is bad for India. Foreign investors are an important part of the Indian economy today and will be even more important for us in the future. Their mistakes generate misallocation in India; they are giving the wrong incentives to low quality managers and projects.

We need to undertake policies through which foreign investors are more integrated into India. Our `Permanent Establishment' rules encourage FIIs to locate offices outside India. Our attempts at source-based taxation encourage routing money through Mauritius. Our capital controls and transaction taxation discourage operations in India; it is better for many FIIs to invest in Indian underlyings through overseas markets. All these policy mistakes increase the information distance faced by FIIs, leading to misallocation, which is not in our interest.

From a practical investment perspective, these results have some interesting implications: FIIs are better off investing in index funds based on the three Fama-French factors (size and B/P in addition to the ordinary index funds on Nifty and Nifty Junior). It is worth buying firms chosen by DIIs but shunned by FIIs. When you see a company which is favoured by FIIs but shunned by DIIs, sell.

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