Ila Patnaik and I have a recent paper in the Journal of International Money and Finance on the investment technology of foreign and domestic institutional investors.
Do the firms chosen by FIIs do well? What is the stock market performance, and the operating performance, in the period after a firm has been selected for investment by FIIs?
This is an important question for many reasons. Investors (both foreign and domestic) would like to know the information content of seeing an FII or DII present in the shareholding of a firm. If, hypothetically, domestic financial regulation hampers DIIs, there may be a special role for FIIs in rationally allocating capital and alleviating financing constraints. If FIIs fare poorly in security selection, as has often been the case in the international finance literature, these mistakes have consequences for the allocation of capital and the incentives of entrepreneurs. Perhaps what India requires is policies that foster deep engagement with international capital, through which FIIs would achieve better information and thus fare better in security selection.
The opportunity for measurement
There is strong evidence of home bias: foreigners own too little of most Indian firms with an ownership of 0 for most firms. Less than a thousand companies have over 1% investment by FIIs. This is true for DIIs also. This opens up the opportunity to see how the chosen companies fare against those that were not chosen. To construct a quasi-experiment, we identify three groups of firms:
- Those chosen by FIIs but not DIIs
- Those chosen by DIIs but not FIIs
- Those chosen by neither.
On the 31st of each year, it is possible to make these three lists of firms. An examination of future performance would give us insights into the investment technology of FIIs and DIIs. Specifically, if the firms chosen by FIIs but not DIIs (i.e. Group 1) do much better than those in Group 3, then we would think that FIIs have a valuable investment technology.
Pitfalls in measurement
Institutional investors are different. Institutional investors are different from individual investors. Hence, a fair comparison is between FIIs and DIIs.
Treatment effects or selection effects or both. Why might a firm fare well after FII investment? There can be two channels. There can be a `selection effect' where FIIs identify better firms. There can be a `treatment effect' where FIIs exert governance, and push firms to behave better. Investment technology is about the overall effect, i.e. the reduced form outcome. The economists' perennial quest for separating out selection effects from treatment effects is inappropriate here.
Asset allocation versus security selection. It is well known that the firms chosen by foreign investors are different in many dimensions such as beta, size, liquidity, etc. This hampers comparison. As an example, when Nifty fares well, high beta firms tend to do well. In such times, the portfolio held by foreign investors will look good as they have loaded up on high beta firms.
In order to address this, we utilise the three Fama-French empirical asset pricing factors: size, B/P and beta. For each firm chosen by the FII (but not DII), we find the partner firm (that was chosen by neither FII nor DII) where the Mahalanobis distance in size, B/P and beta is the lowest. If a good match cannot be found, the firm is dropped. This gives us a series of pairs of firms, which are alike in size B/P and beta, where one got FII (but not DII) investment and the partner got neither.
Holding a money manager accountable for security selection after controlling for asset allocation is an old idea in finance. However, the application of this idea into the question of investment technology of FIIs and DIIs is new, as is the matching-based quasi-experimental strategy through which we control for the asset allocation.
We find that the firms chosen by FIIs have exuberant growth in fixed assets in the following 3 years. But their output growth is not commensurately strong; there is some evidence of a decline in productivity. In terms of stock market performance, these firms under-perform over the three years after observation date.
Firms chosen by DIIs are strikingly different. They seem to be firms that are retrenching: both capital and labour drop slightly. But output grows. There is productivity growth. In terms of stock market performance, these firms outperform by 18 percentage points over three years.
These results suggest that foreign investors have a weak investment technology. Their access to information, and their ability to process information, adds up to poor security selection. In contrast, DIIs -- who are present in India and are likely to have ample information about portfolio companies -- fare better.
Implications for persons analysing Indian securities. A firm which has FII investment but not DII investment is probably going to grow assets but not give strong results. Conversely, a firm which has DII but not FII investment is likely to have slow growth but improve productivity and deliver stock market returns.
Implications for foreign investors. The results of this paper are about the average foreign investor, and there are surely many foreign investors who fare very well on security selection. However, on average, foreign investors need to be more cautious about their activities in India. They need to either amplify their efforts in security selection, so as to achieve strong information and information processing on Indian firms, or not attempt security selection.
How can a foreign investor improve security selection? Two paths are visible: To establish operations in India, and hold the team accountable for security selection using the methods of this paper, or contract-out to money managers who have deep roots in India.
How can a foreign investor harness asset allocation to India without attempting security selection? It is possible to setup index funds for the three Fama-French factors and thus replicate the bulk of the desired portfolio characteristics.
Implications for policy makers. Many of the pathologies of international finance are rooted in asymmetric information and the lack of deep engagement of foreign investors. These results are a reminder that even a large emerging market like India suffers from these problems. It is in India's interest to have a deep engagement with foreign capital, so as to obtain higher allocative efficiency. This suggests a re-examination at the constraints placed against deep engagement by foreign capital:
- It is difficult for foreign investors to contract-out money management to locals.
- `Permanent establishment' rules by the tax authorities have encouraged foreign investors to not open offices in India. This hampers deep engagement. Offices in Singapore or London will not be able to match the information and information processing that can be done in India.
- Source-based taxation, capital controls, and taxation of transactions, give incentives for foreign investors to avoid transacting in India. It is cheaper for a foreign investor to invest through the PN and NDF markets. However, not being in India hampers deep engagement.
How might this change over time?
In my opinion, in the 2000s, a certain kind of Indian entrepreneur started producing companies that look good to foreign investors. But you can't fool all the investors all the time. I think many investors are now more circumspect. Wall Street is changing course, and this is changing incentives for entrepreneurs. When finance rewards honest businessmen, more honest businessmen will show up asking for capital from the financial system. Many years from now, we might say that the results of this paper described a moment in time in the evolution of Indian capitalism.