The optimism seen in the Indian market last year has been sorely missing in 2011 as a precariously placed global economy — thanks to the lingering problems in Europe and the US — has given investors reasons to reduce exposure to risky assets, including equities.

While equity markets the world over have been under pressure, In dian benchmark indices have been the worst-performers with the benchmark Sensex tumbling 21 per cent over the past nine months owing to large selloffs by overseas investors.

Foreign institutional investors or FIIs, the main driver of the Indian equity market for the past several years, have been on the forefront in dragging down the market. They have pulled out close to Rs 2,000 crore from domestic equities so far this year after infusing nearly Rs 1,33,000 crore in 2010. In September, FIIs have so far sold shares to the tune of Rs 1,500 crore.

A big selloff by FIIs may break the back of the market as was seen after the Lehman collapse in 2008. FIIs had sold shares worth Rs 53,000 crore in the Indian market following the sub-prime mortgage crisis, trig

gering a 52 per cent drop in the benchmark Sensex.

When FIIs returned, they bought equities worth over Rs 85,000 crore and Rs 1,40,000 crore, respectively, in the next two calendar years, and the market rebounded smartly.

A similar crash cannot be ruled out completely if the tremors in the euro zone develop into a fullblown crisis. For, FIIs today own majority stakes in more than two-thirds of companies in the Nifty basket, while domestic financial institutions continue to struggle when it comes to raising funds from investors.

Overseas investors have been finding it tough to keep going this year due to redemption pressures ba f ck home and a bleak glob al economic outlook. But they contine ued to rule the roost as they held r higher stakes that domestic financial s institutions in more than 35 compa0 nies in the Nifty basket as of June 30, g according to data compiled by Capitaline. In companies constituting the Nifty50 index, FIIs have huge stakes in HDFC, Hero MotoCorp, Hindustan Unilever and Jindal Steel, among oth ers. They held 33.67 per cent stake in Hero MotorCorp compared with just 4.56 per cent held by domestic insti tutions as on this past June.

In HDFC, FIIs held 73.11 per cent compared with 14.27 per cent held by domestic institutions.

Now it remains to be seen whether they can maintain their dominant position in the domestic market or buckle under pressure amid the global turbulence as it may lead to further unwinding of positions. On their part, domestic institutional investors have adopted a more aggressive strategy this year purchasing equities worth nearly Rs 7,000 crore as attractive valuations encouraged them to buy good stocks at cheaper levels.

Despite financial constraints, domestic institutions, which comprise insurance companies and mutual funds, have good hold on several blue-chip com panies. As on June 30, they held nearly 36 per cent in ITC, 19 per cent in Cipla, 21 per cent in BPCL and 8 per cent in NTPC.

Saurabh Mukherjee, head of equi ties at Ambit Capital, felt lack of clar ity in the global scenario and worries about possible sovereign defaults in the west could force foreign investors to cut investment in emerging markets, including India.

“We see the possibility of more foreign funds pulling out of the Indian market this year, as a bleak global economic outlook and lack of positive triggers will see more fund erosion,“ Mukherjee said.

Other market experts felt although overseas investors have remained net sellers of equities this year, India's strong economic growth prospects will be a major draw for them.

Gurunath Mudlapur, managing director at Atherstone Capital, said FII selling has been the result of bad market conditions prevailing across the globe as they understood the importance and long-term benefits of staying in the Indian market.

Despite several challenges, India's economy will expand 7.8 per cent this year compared with an 8.2 per cent projection made in June, the International Monetary Fund said in its World Economic Outlook report on September 20.

“Although, selling by FIIs may lead to churning in several stocks, it will not lead to any meaningful retreat from the Indian market. Even though, we have seen such instances in the past, FIIs are known to be long-term players as they value our growth potential in the coming years,“ said Mudlapur.

The ownership of FIIs has been predominantly higher in most `A' group stocks, which constitute more than 50 per cent of the overall market-cap. While many analysts and broking houses are predicting muted earnings growth for the July-September quarter, most companies have managed to overcome higher input costs by raising prices.

“We are seeing a temporary setback in the domestic market, but our fundamentals are very strong compared with some of the bigger economies. With India still poised to grow at 7 per cent and earnings at double-digit levels, FIIs will make a comeback for better returns,“ said Abbas Merchant, senior AVP for research at Jaypee Capital Services.

According to Merchant, although domestic financial institutions have been doing well in the present market scenario, they lack the financial muscle compared with the FIIs, which invest in fundamentally good companies in bulk.