Is there correlation between flows and returns?

That markets do well when overseas inflows go up and correct when foreign institutional investors (FIIs) press the sell button is a popular adage heard on the Street. However, an analysis of net institutional investor inflows and market returns shows it is more than just net inflows that drive the market. For instance, so far in 2017, net inflows of close to $3 billion have come in but the markets have climbed 11.2 per cent, in contrast to 2014, when the markets got net inflows of just $629 million but the Sensex soared 30 per cent. While the flows are important, sentiment is a bigger factor than liquidity, says a report by Kotak Institutional Equities. For instance, if tomorrow the US Fed cuts the interest rates by 100 basis points, stocks will go up sharply without any meaningful inflows. There is no correlation between institutional activity and market returns, says the brokerage as technically every secondary market trade includes selling and buying, resulting in zero net flow.

Actual “liquidity” is the “prevalent sentiment of the market, which is based on expectations about either improvement or deterioration in fundamentals (primarily earnings) or continuation of prevalent trends,” the note says. 

“We can only hope that the current excitement about the Indian market, especially the mid-cap and small-cap, stocks reflects the market’s confidence in a sharp recovery in economic activity and earnings and not simply expectations that the market and underlying stocks will deliver positive returns simply based on ‘liquidity’ and increased ‘participation’ by retail investors into the market,” the note adds.