INDIANS have often been accused of aping the West, whether it's in fashion or management practices. So, it would only be natural if domestic fund managers took their cues from bigger and more experienced counterparts such as foreign institutional investors (FIIs), while taking investment decisions. But as always, India is full of surprises and this year's ET500 list reveals that both domestic mutual funds (MFs) and FIIs have their own ideas about where the money lies.

A sample of the 30 most favourite stocks (which also figure in ET500) among FIIs and domestic MFs shows that the former has a greater preference for banks (21%) and infotech (21%) stocks, while the latter is more upbeat about capital goods (24%) and auto ancillaries (13%). Not surprisingly, FIIs also seem to prefer large-cap and mid-cap companies, whereas MFs place their bets on upcoming mid-cap and small-cap companies. FIIs' total stakeholding in ET500 companies stands at around 9% (median value), which is considerably higher than the 4% stake held by MFs.

MFs seem to prefer investing in sectors/companies which are the flavours of the season. So, it's not surprising that currently, their favourite stocks are in sectors like capital goods, auto, auto ancillaries, textiles, construction, pesticides & agrochemicals, steel and pharmaceuticals. FIIs, on the other hand, tend to go in for old favourites like banks, IT and financial service providers.

So, how can one explain this divergence in investment philosophy of FIIs and MFs? We believe it's a combination of history and difference in the sources of funds and investment horizon. Foreign investors have been investing in the Indian equity market for a decade-and-a-half, whereas MFs are relatively new entrants. Doors to foreign portfolio investment were first opened in 1992 and FIIs have been building their portfolio since then.

At that time, government-owned Unit Trust of India (UTI) was the only MF player in the market. The other institutional players were LIC and GIC. However, just as FIIs began to accumulate domestic stocks, UTI's largest scheme, US-64, collapsed in the mid-'90s. This resulted in a virtual freeze in fresh secondary market purchases by UTI, while LIC and GIC were still smaller. This offered FIIs an uncontested space in the institutional category to accumulate the best pickings in the secondary market at historically attractive prices. Not surprisingly, FIIs are now the majority/largest equity holders in some of the biggest ET500 companies such as HDFC, ICICI Bank, IVRCL, Satyam Computer, Amtek Auto, among others.

Overseas institutional investors had accumulated these scrips long ago and stayed invested, waiting for returns to flow in. Their investment decisions were based on considerations like economic and fiscal reforms in India, and potential growth sectors and companies.

When the Indian economy began to surge, most of these companies were the first to gain from its growth. As the earnings of these companies grew, their stock prices zoomed. Now, most of these stocks are trading at their historically high price-to-earning multiples and are considered too expensive for MFs to make money. Another issue is that very often, there may not be enough free floating shares of these companies in the market.

When domestic MFs started investing sizeable amounts in the secondary market, apart from FIIs, they also had to compete with fast-growing insurance companies, not to mention high net worth individuals (HNIs) and retail investors.

Low hanging fruits were typically not available. They needed to innovate and take risky bets, which meant investing in riskier, but potentially high-growth mid-cap and small-cap stocks. Not surprisingly, nearly half of the most favourite stocks (among ET500) of MFs belong to the mid-cap and small-cap category, while only 17% fall in the large-cap category. On the other hand, one-third of FIIs' most favourite stocks continue to be large-cap ones.

Another factor working behind the scenes is the difference in the source of funds for FIIs and MFs. Though detailed data is not available, the prime sources of funds for FIIs are foreign insurance companies, HNIs, pension funds, endowments, retirement funds and individuals. Most of these entities are medium-to-long-term investors. This helps FIIs to make equally long-term bets on the Indian equity market.

In contrast, the bulk of the investments in MFs is generated by corporates and HNIs, who use various MF schemes to park their surplus funds and seek quick returns. This means MFs have to seek stocks which are risky, but have the potential to generate good returns in the short term. This may be one of the reasons why the net equity investment of MFs fluctuates year-on-year.

FII investment, on the other hand, continues to rise steadily. FIIs have been net buyers every year since 1992, except two years in between. MFs, on the other hand, turned buyers as late as '03. During the past couple of years, when the Sensex touched record highs and continued to move northwards, domestic investors suddenly realised the missed opportunity.

They are now investing heavily in MF equity schemes and have turned net buyers. It is a known fact that higher the risks, better the returns. By this logic, MFs should earn higher returns. But investment data shows that FIIs are smarter.

Less than a quarter of the top 30 FII stocks gave negative returns last year. The corresponding figure for MFs was more than double, at 47%.

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