S N Mehta (name changed) is an "informed" investor in the stock market. He knows the difference between the book value and market value of a stock and tracks the P/E (price-earnings) ratio of various sectors before investing in the market. He makes it a point to book profits before the calendar year ends and make fresh investments at the beginning of the year.

Why does he do this? Mostly, because of a conventional notion about foreign institutional investor behaviour. FIIs, it is thought, book profit at the year-end because US investors go on a redemption spree at that time.

After booking profits, the FIIs return to the market with bags of funds in the new-year when they make fresh asset allocations for different markets in the world, including India.

Mehta is one of many investors who has been spreading this myth. Actually, FIIs can book profit at any opportune moment of the year. There is no redemption pressure by their investors at the end of the year.

They exit any market whenever they smell trouble. And, finally, they don't wait till January to make fresh asset allocations. Fresh allocations (or cutbacks) can be done anytime in the year for any market.

The FIIs review asset allocation on a yearly, half-yearly, quarterly, monthly, fortnightly, weekly and even daily basis! While regular reviews are done through teleconferencing, more comprehensive off-site meetings do take place periodically.

What's the origin of the Myth Number One? It could possibly be tracked back to the bonus system for fund managers. Traditionally, the bonus is distributed at the beginning of the year based on the fund manager's year-end performance.

Earlier, the performance was determined on the actual profit booked. But now the net asset value of a portfolio determines the quality of fund management so managers do not need to sell stocks and book actual profit to impress the company. So the year-end profit booking theory does not hold water.

Of course, managers of hedge funds still get their bonus on the actual profits booked. But the Indian markets are dominated by FIIs and not hedge funds.

Now let's look at Myth Number Two: FIIs are under redemption pressure during the year-end, which triggers profit booking. Nothing can be further from reality. Pension funds, provident funds and high net worth individuals are the main investors in the $ 7 trillion US mutual fund market.

These investors have no compulsion to redeem units by the year-end. Corporate pension funds press for redemption only when there is a mass retirement of employees in the offing. And because employees tend to job-hop every two or three years, US companies rarely see retirement in large numbers in any industry.

In a typical case, a Fortune 100 company gives the mandate for managing its few million dollars worth of pension funds to three or four fund managers. The funds' performance is reviewed every year and if the company is not happy with a particular fund, it withdraws the mandate from one fund and gives it to another. Even in this case, there is no selling pressure since it is the portfolio that changes hands, not the fund invested in the market.

Finally, let's deal with Myth Number Three: fresh asset allocations at the beginning of the year. Typically, an FIIs' asset allocation committee consists of the global asset allocator, regional or emerging market asset allocator, a country specialist and a sector specialist.

The combination of country specialist and sector experts creates a model portfolio for a particular country. Once this is endorsed by the committee after hard lobbying, it gets reviewed on a continuous basis. There is often a convergence of recommendations and this has been the case with certain FIIs at this point of time.

Mind you, this was not done in the beginning of calendar year 2003. Had this been the case, the FII money would have come in at the beginning of the year and the market would not have waited till June to see foreign funds pouring in money.

Indeed, the tempo of FII investment started in June when net inflows was Rs 2,611.7 crore (Rs 26.12 billion) and climaxed in October when net inflows touched Rs 6,862.6 crore (as the chart shows, that's more than the yearly net FII inflow into the equity market in each year between 1994 and 2002 except 1996 and 2001).

In January, net inflows were Rs 1,065.6 crore (Rs 10.66 billion). They dropped to Rs 405.5 crore (Rs 40.5 billion) in February, Rs 252.6 crore (Rs 25.3 billion) in March and then rose to Rs 549.8 crore (Rs 5.5 billion) in April before crossing the Rs 1,200-crore (Rs 12 billion) mark in May. Don't these figures prove that the FIIs review their asset allocations continuously and do not wait for a particular time to make their call on markets?

It is in indeed true that there is a slowdown in FII investment in November. It could get even worse in December. But the reasons for this are different: it's logical to book profits when the markets are on a roll.

Where does one see FII investment in the Indian markets next year? Despite Goldman Sachs's famous BRIC report, few FIIs are over-weight on India even now (possibly Prudential, Capital International, Government of Singapore, Janus and a few others fall in this category).

However, some of them are changing their India stance from under-weight to neutral. What does that mean? By a rough calculation, the emerging market asset allocation by the FIIs could be $100 billion a year. On various emerging market indices, the weight on India is around 5 per cent.

In other words, around $5 billion from the $100 billion kitty could come to India when the overall stance is neutral. This is what we have seen this year.

If more and more FIIs change their stance, those that were under-weight on India and had not invested in local markets earlier could rush in with funds. This will swell the kitty to much above $5 billion. In the most optimistic scenario, more and more FIIs could go overweight on India and Asia. In that case, the inflow into the equity market next year can double this year's flow.

The elections may hold the key for the FII outlook on India next year. But at the structural level, an increase in floating stock or free float will encourage the FIIs to tap the Indian markets more aggressively. (Free float is the amount of a company's stock that is available for trading and excludes the promoters' holding. It can be increased through initial public offers and divestment of government holdings in public sector undertakings.)

In mid-October, the FIIs held 45.23 per cent of the free float market capitalisation of the Bombay Stock Exchange Sensex stocks. This is 3.23 percentage points higher than their holdings on June 30. The FIIs now collectively own over 40 per cent of the free float in the top 100 traded companies.

The FII holding in the market capitalisation of Sensex stocks increased from 24.91 per cent in March 2003 to 25.46 per cent in June and 27.92 per cent in the quarter ended September.

Also, FII holding in the outstanding shares of the 30 Sensex stocks increased from 20.86 per cent in March to 24.14 per cent in September. The FIIs have increased their stakes by 2 to 4 per cent each in most of the front-line stocks.

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