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Suresh Krishnamurthy

FII inflow into mutual funds is good for the Indian stock market but not necessarily for the retail investor in mutual funds. He may need to scale down return expectations if mutual funds change strategy to suit the larger investors.

THE expected entry of foreign institutional investors (FIIs) through mutual funds, as reported recently, is a positive event as far as the equity market is concerned. Mid-cap stocks and, by extension, small-caps, seem set to benefit from their entry into mutual funds. If FIIs put in sizeable sums, it would also be a vote of confidence for fund managers.

Their entry, however, may not turn out to be completely positive for the mutual fund investor. If the investment strategy is changed to suit the larger institutional investor, the mutual fund investor will have to comfort himself with lower returns. Direct investing in mid-caps and small-caps may then be necessary to earn better returns.

Mid-caps to gain: One of the impediments to greater foreign institutional investor participation in the Indian markets is the lack of availability of a sufficient number of large-cap stocks.

Although FIIs are picking up small stakes in mid-caps, they are comfortable holding large stakes only in companies with market cap in excess of Rs 10,000 crore. We have only a few such companies. This restricts the flow of FII money into the country.

Now, FIIs seem set to overcome this barrier by investing through mutual funds. Investing through mutual funds will help FIIs take exposure to the mid-cap story more meaningfully. It would also help them take exposures at more attractive prices. The entry of FIIs into a mid-cap stock is sufficient to push the stock price sky-high.

The beneficiaries of their entry would, in the end, be a number of mid-cap stocks. The PE multiple of stocks with market capitalisation of between Rs 1,000 crore and Rs 5,000 crore, in particular, may rise in value. This is especially if these stocks are quoting at a discount to their large-cap peers.

A number of such stocks have already gained in value and may rise further as liquidity at their counters rises.

The sellers, usually the Indian public, in these mid-caps may put part of their money into small-cap stocks. As such, small-caps, too, might benefit over a longer-term.

A vote for MFs: The entry of FIIs into MFs is also a signal that the performance of Indian mutual fund managers has been impressive over the past five years. Until now, mutual fund investors in India have had no information to benchmark the performance of MFs against other institutional investors in India.

Several analysts with brokerage firms also used to subtly hint that mutual funds are per se doing well for Indian retail investors but are under-performing other skillful institutional investors. There is now evidence that the performance of Indian mutual funds is not inferior.

For instance, Motilal Oswal, one of the larger Indian brokerage firms, indicated that its portfolio management scheme had gained 160 per cent on a post-tax basis in 2003-04. Many Indian mutual funds have done as well or even better.

In addition, since Indian mutual funds handle larger sums than these brokerage firms, their performance appears even better. Now, with FIIs seemingly willing to put their money into Indian MFs, they are acknowledging that the latter's performance is nothing to be scoffed at.

Mixed bag for MF investors: For the mutual fund investor, however, the entry of large institutional investors into their schemes may not be completely positive. Inflows of FIIs over the past many years have been stable.

There is no evidence that FIIs enter and exit in a hurry. They are long-term investors.

From this perspective, the flow of long-term money would lend stability in the size of assets and help the fund manager plan better.

On the other hand, FIIs may be too keen on liquidity. This will force the mutual funds to hold on to large-cap stocks that may otherwise be considered fully valued. MFs, which are already loath to completely sell over-valued large-cap stocks, may stick to them even more.

This would be the case especially if the size of inflows increase each year. This would necessarily reduce returns for the retail investor. Retail investors may then need to focus on direct investing in stocks to get better returns.

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