How to FII-proof your portfolio :: Business Line

Reduce your Indian equity exposure, buy US stocks via mutual funds, and lighten up on gilt funds to reduce risks from the end of QE.

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Irrational, knee-jerk, hopping mad – market experts went overboard with their adjectives last week as the Sensex plunged on worries that the US Fed would close the liquidity tap. But why, exactly, is it irrational for stock markets to tumble on worries about foreign investors pulling out?

No one complained about irrationality when a flood of inexplicable liquidity buoyed up stock prices in the last two years.

It was the $38 billion in Foreign Institutional Investor (FII) purchases, in short - liquidity, that powered the Sensex up by 33 per cent between January 2012 and May this year.

It certainly wasn’t the fundamentals. With the economy in a slump, the profits of Sensex companies (a proxy for India Inc) have grown barely 4 per cent over this period.

Therefore, there is no doubt that it is a big worry for stocks (and bonds and gold) if this supply of easy money is staunched by the US as it cuts back on its quantitative easing (QE) programme. While it isn’t clear when this withdrawal will happen, investors can prepare for it by overhauling their portfolio.

LIGHTEN UP ON STOCKS

So how do you rejig your portfolio today to prepare for an FII exodus? If you are heavily invested in stocks (60 per cent or more of your portfolio) book profits to rebalance it to, say, 50:50. It is best to withdraw any money that you need within two years entirely from the stock markets. This goes for money parked in equity funds too.

While selecting stocks to sell, first go for the ones that trade at high valuations or have a weak profit trajectory in recent quarters. This is where FIIs may choose to take profits first.

Avoid holding stocks where impact cost from FII selling is likely to be high. Own fewer mid-cap and small-cap stocks in your portfolio and stay with large-cap or index names.

With the rupee under fire, diversifying your equity portfolio by owning an international fund seems to be an excellent idea now. Funds that invest in US stocks appear the best bet to play on US economic recovery as well as a stronger dollar. Avoid investing in emerging market funds as it is akin to jumping from the frying pan into the fire.

CAUTION ON DEBT FUNDS

A reversal in liquidity could trim returns from your debt portfolio too. Long-term debt and gilt funds have had a splendid run in the past year with 15 per cent-plus returns made mainly on the back of price gains. Predictable interest rate cuts from the RBI set off this rally and rising FII investments in debt added fodder to it.

But bond prices could now witness a reversal if FIIs begin to withdraw money from Indian markets. Pressure on the currency could also force the RBI to slow down the pace of its rate-cuts. This would limit bond price gains and trim returns from gilt and debt funds. In this scenario, funds which have packed their portfolios with long-dated bonds could suffer a bigger setback to their returns than those with short-term bonds. Lack of FII appetite for government bonds could also keep bond prices under check.

Even if debt market trends don’t pan out exactly as above, investors need to brace for a period of higher volatility in bond prices. They, therefore, can no longer take double-digit returns from gilt or long-term debt funds for granted. Locking into avenues offering predictable returns, such as fixed deposits, may be a better option for conservative investors.

WHAT ABOUT GOLD?

With both equity and debt markets headed for more turbulent times, can one seek solace in gold? Well, opposing forces seem to be pulling at gold price returns now.

The gold bull-run in recent years has been partly powered by QE money. Lower liquidity sloshing around in the global markets could therefore dull the sheen for gold. It is this fear which has triggered the 19 per cent fall in global gold prices in the last three months. But then, Indian gold ETFs (exchange traded funds) gain from every uptick in the dollar’s exchange rate. This is why they have managed to contain their fall to 10 per cent. So hold on to gold funds as a portfolio diversifier, but limit the holdings to 5-6 per cent of your portfolio.