ETMarkets Smart Talk| Despite FII selling, smart money shifts to small and mid-caps, says Vivek Rajaraman

Even as foreign institutional investors (FIIs) continue to offload large-cap stocks, the so-called smart money is quietly shifting towards India’s small and mid-cap space.

In an exclusive interaction with ETMarkets Smart Talk, Vivek Rajaraman, Executive Director and Head – Client Advisory at Waterfield Advisors, explains why FIIs are taking a selective approach, the sectors drawing their attention, and how domestic investors are cushioning markets amid persistent global uncertainties.

Edited Excerpts –

Q) How is this sovereign rating upgrade likely to influence overall equity market sentiment, especially in terms of foreign institutional investor (FII) inflows?
A) The ratings upgrade will have a positive influence on the overall equity market sentiment. An improved risk perception, coupled with a lower cost of capital, adds to a wider eligibility for global funds to allocate more to India.

An immediate impact could potentially trigger passive fund inflows from indices that have minimum rating requirements, but a longer-term change would involve FIIs reducing country risk premiums as they factor that into their return calculations.

A secondary impact could be a spillover from the bond market, where FIIs looking at increasing allocations to Indian bonds would simultaneously raise equity exposure.

Q) Could improve ratings prompt a strategic reallocation from debt to equity among global asset managers, and which sectors might absorb this shift?
A) This could happen, though it is early days to see how fast that shift happens. A sovereign upgrade narrows spreads on Indian government and corporate bonds.

As government bond yields fall due to improved creditworthiness, the relative attractiveness of equity risk premiums increases. Global investors (especially asset managers running balanced EM portfolios) may rebalance into equities to capture higher returns, once macro risk perception is lower.

While not a wholesale move, even a 1–2% reallocation of large EM multi-asset pools into Indian equities can mean significant fresh inflows, given India’s scale in global indices.

Q) Which sectors are expected to benefit most from the rating upgrade?
A) The biggest beneficiaries are interest rate-sensitive sectors such as banks, infrastructure & capital goods, real estate and utilities.

Consumption and staples would not necessarily benefit directly, but a stronger currency and the ability to withstand imported inflation can boost purchasing power.

- Banks: lower sovereign risk translates into lower cost of capital. Improved credit ratings cascade down to corporate borrowers, lowering NPA concerns.

- Infrastructure, Capital Goods and Industrials: ratings upgrades often spur government and private investment cycles and cheaper external borrowing directly improves balance sheets of infra players.

- Others: Real estate will benefit from the lowering of borrowing rates, and cement as a proxy for this sector. Utilities (high capex sectors) and renewable energy can attract long-term global ESG funds.

Q) What is your take on the June quarter results for India Inc.? Are managements more confident about the future amid tariff threats?
A) Overall, broad markets experienced slow earnings growth in Q1 FY26, with headline earnings rising 8% year-on-year, largely supported by oil and gas sectors.

Revenue growth across listed companies was modest, with some sectors like cement, autos, defence, and hospitals showing strength. Cement earnings surged 43% year-on-year, and defence majors posted over 25% earnings growth.

Auto sector gains ranged around 11–12% with companies like TVS Motor and Mahindra & Mahindra reporting strong profits.

However, I feel business confidence among Indian firms remains robust and is improving. The National Council of Applied Economic Research (NCAER) Business Confidence Index rose sharply to 149.4 in Q1 FY26 from 139.3 in the previous quarter, with firms showing broad optimism.

While U.S. tariff pressures are acknowledged, firms are diversifying into other markets like the UK, while others adapt through cost optimization.

Overall, managements appear cautiously optimistic amidst global trade concerns and tariff threats. They see near-term challenges but expect government capex, private sector investment, and rural demand improvements to aid growth in the medium term.

Q) Where is the smart money moving? We are seeing selling by FIIs and DII/institutional and retail investors doing much of the heavy lifting.
A) Current data reveals that Foreign Institutional Investors (FIIs) have been selling Indian equities significantly in 2025, including a sizable sell-off of about INR79,344 crore (~$9.2 billion) till July.

The sell-off intensified in July and August with FIIs offloading INR24,723 crore and roughly INR14,000 crore worth of equities, respectively.

This selling pressure has been particularly strong in large caps, especially IT, metals, public sector banks, and the pharma sectors due to global concerns, elevated valuations, and tariff threats.

Despite this FII selling, Domestic Institutional Investors (DIIs), including mutual funds, along with retail investors, have been doing much of the heavy lifting.

DIIs have persistently been net buyers, cushioning the market from the FII outflows with net purchases well over INR50,000 crore in August so far, showing strong confidence in Indian equities. This domestic buying support helps maintain market stability even as FIIs hedge and reduce exposure in large-cap stocks.

Interestingly, FIIs are not exiting the Indian market entirely but are reallocating their bets towards small and mid-cap stocks, which are deemed less vulnerable to global shocks.

FIIs have increased holdings in more than 260 small-cap companies, particularly in sectors like auto ancillaries, specialty chemicals, defence manufacturing, healthcare, and select financial services, seeking growth potential beyond the headline large caps.

I believe this dynamic signifies a phase where the market breadth is increasing and while domestic investors are driving the market currently, FIIs are adopting a cautious, selective approach, focusing on growth and diversification away from global risk-sensitive large caps.

Q) How can one earn or get financial freedom say at the age of 50 by investing in equity or equity related instruments?
A) The best advice anyone can get is to start investing early. The power of compounding really manifests itself over a long period of time with minimal disruption.

However, I would add that this approach requires active monitoring and active oversight, even if there is no call to action. It is commonly assumed that we should choose an index fund, regularly invest in it and forget it.

There are numerous occasions across the world where this way of investing may not have worked – careful planning, accounting for cash flow requirements, understanding risk tolerance and using a systematic approach towards monitoring and rebalancing are steps to achieve financial freedom.

Q) Any implication from the US-Russia summit which investors should be keep an eye on?
A) The recent US-Russia Alaska Summit ended without a peace agreement on the Ukraine conflict. The US continues to pressure India to reduce imports of Russian oil through tariffs.

India faces a combined 50% tariff on exports to the US due to its Russian oil purchases, complicating trade relations and potentially impacting export competitiveness.

A bill in the US Congress proposes even harsher secondary sanctions with tariffs up to 500% on countries seen as supporting Russia’s war economy, which could escalate economic tension for Indian exporters.

At the same time, despite the summit's failure to reach peace, the diplomatic engagement suggests ongoing US-Russia strategic dialogue, signalling potential shifts in geopolitical alignments that could influence global markets, energy supplies, and defence sectors.

A follow-on meeting with the Ukrainian president, Vladimir Zelensky and European leaders had a marked shift in tone as compared to President Trump’s earlier meeting in February this year.

Investors should closely monitor how secondary sanctions evolve, as these could impact sectors tied to Russian imports, including energy, refined petroleum, and exports that depend on the US market.

India is currently balancing energy security through Russian oil imports against maintaining good ties with the US amid tariff pressures. This tension could influence investment sentiment, especially in energy, export-oriented sectors, and geopolitical risk-sensitive assets.

Q) US market hit fresh highs, Bitcoin too hit fresh highs – where are we stuck?
A) The US markets over the last couple of years and even of late since April, have shown a very distinctive skew. The top 10 stocks account for 56% of the S&P500’s increase in value since the market bottomed on April 8, 55% of the growth in net income for the index over the past 12 month and 69 per cent of the growth in capital expenditure for the index over the past 12 months.

The remainder of the S&P500 do not trade at such high valuations and nor do US Mid and Small capitalisation companies. Bitcoin has found new legs after getting an ETF vehicle and more institutionalisation after President Trump endorsed and encouraged cryptocurrencies via accommodating regulations.

Indian markets have also recovered from March lows, but expensive valuations and moderate earnings growth have limited the upside till now. With a new round of GST reforms taking shape, we are well poised for the next round of earnings growth to come through.

Q) Any sectors which investors should keep on their radar?
A) Consumption-driven sectors should see a boost due to the GST rate reduction. Quick service restaurants, rural consumption, and discretionary consumption companies, which have largely been laggards in the last couple of years, should see earnings revival due to this change.

Lending financials and NBFCs should also benefit due to increased activity in this space. From other sectors, I can see defence continuing to get government support and focus, though I will have to be wary of valuations.

(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)