Foreign investors may return to trade Indian equities before making a long-term structural allocation

Foreign institutional investors (FIIs) have remained a major source of pressure for Indian equities over the past two years, with foreign investors withdrawing nearly $40 billion from Indian stocks during the period. According to a recent note by Bernstein analysts led by Venugopal Garre and Nikhil Arela, the environment for a sustained revival in foreign investment remains challenging.

Bernstein believes FIIs could return to Indian equities as traders as some near-term headwinds ease, but a meaningful return of long-term foreign capital could require deeper changes in India's corporate and industrial landscape.

The brokerage expects FII flows over the next 12 months to be flat to modestly positive. However, it said this expectation is primarily based on the possibility of easing near-term pressures rather than a major improvement in the structural factors that influence long-term foreign allocation decisions.

FPI Selling Has Resumed in September

The latest flow data highlights the volatility in foreign investor participation. After turning net buyers in July and August, FPIs returned to selling in September.

According to data reported by Business Standard, FPIs had withdrawn ₹20,974 crore from Indian equities through September 18. This followed inflows of ₹20,200 crore in July and ₹29,630 crore in August. The cumulative FPI outflow from Indian equities in 2026 had reached about ₹2.45 trillion by September 18.

The September reversal has been associated with several global factors, including elevated US interest rates and bond yields, higher crude oil prices, geopolitical uncertainty and pressure on the Indian rupee.

At the same time, foreign investors have continued to participate in India's primary market, indicating that their approach is not simply an across-the-board exit from Indian assets.

Why India's "Bright Spot" Story Is No Longer Enough

Bernstein's assessment is based partly on the relative returns generated by Indian equities. The brokerage noted that the Nifty has delivered only around 6 per cent annualised returns in US-dollar terms over the past decade, while its annualised decline over the previous two years had been close to 11 per cent.

For global investors, returns must therefore be considered alongside valuation, currency risk, liquidity and the opportunity available in other markets.

The implication is that India's long-standing status as a structural growth market may not by itself be sufficient to attract large incremental foreign allocations. Global investors can compare Indian opportunities with markets where valuations, technology exposure or earnings growth may offer different risk-return characteristics.

Large-Caps Face a Structural Challenge

One of Bernstein's central arguments concerns India's large-cap companies.

The brokerage described the current structure of India's large-cap market as representing a "bygone economic era", arguing that several established companies are focused more on consolidating existing businesses than investing aggressively in emerging industries.

Bernstein's broader concern is that large companies with substantial financial resources have not yet created enough globally competitive businesses in some of the industries expected to drive the next phase of economic growth.

This matters for FIIs because large-cap stocks are generally easier for global institutions to access at scale. If these companies cannot deliver sufficient growth, foreign investors may need to move further down the market-cap spectrum.

The Mid- and Small-Cap Problem

India's small- and mid-cap universe offers a large number of businesses and potential growth stories, but Bernstein believes institutional investors face practical challenges in allocating substantial capital to this segment.

Many companies remain relatively small, have limited free floats and lower trading liquidity. Coverage by global research teams can also be limited.

For a large foreign fund, identifying a potential future market leader is only one part of the investment process. The stock must also have sufficient liquidity and institutional accessibility to accommodate a meaningful position.

This creates a structural dilemma: large-caps may not provide enough growth in some areas, while smaller companies may not be sufficiently scalable or liquid for large global investors.

India's Next Growth Engine Could Influence Foreign Flows

Bernstein believes a sustained revival in foreign investment will ultimately depend on India's ability to build globally competitive industries in emerging sectors.

The brokerage specifically highlighted advanced semiconductor manufacturing, batteries and energy storage, greater energy self-sufficiency and businesses capable of gaining meaningful global market share.

This is an important distinction between short-term trading flows and long-term investment allocations.

Foreign investors can return temporarily because valuations become attractive, crude prices decline, global liquidity improves or a specific sector enters favour. A structural allocation, however, generally requires confidence that a market can generate competitive and scalable businesses over many years.

AI Investment Theme Remains a Missing Piece

Another challenge identified by Bernstein is the global artificial-intelligence investment cycle.

AI has become one of the major investment themes driving capital towards semiconductor, computing infrastructure and technology companies globally. Bernstein argued that India currently has limited exposure to this type of large-scale AI investment opportunity.

Recent global market commentary has similarly pointed to the lack of a major AI investment theme in India as one factor affecting the country's appeal to some global investors.

For India to attract more structural foreign capital, the opportunity may therefore need to extend beyond domestic consumption and traditional services into globally competitive technology and manufacturing businesses.

Domestic Investors Are Increasingly Absorbing FII Selling

The changing ownership structure of the Indian market is another important development.

Domestic institutional investors have increasingly absorbed foreign selling, reducing the extent to which FII outflows translate directly into sustained market weakness.

Business Standard reported that DII ownership had risen to 19.5 per cent, while FPI ownership of the Nifty 50 free float had declined substantially over the period from September 2023 to June 2026.

This suggests that India's market structure is becoming less dependent on foreign capital than it was in earlier cycles. Domestic mutual funds, insurance companies and other institutions have become an increasingly important source of liquidity.

FII Flows Could Remain Highly Cyclical

Bernstein also highlighted the historical cyclicality of foreign and domestic institutional flows.

According to the brokerage, previous cycles typically involved two to three years of foreign inflows followed by a period of weaker FII activity, during which domestic institutional flows became more prominent.

There have also been periods when both foreign and domestic institutions were significant buyers. Bernstein cited 2023 as a recent example.

The current environment could therefore represent another phase in this broader institutional-flow cycle rather than a permanent withdrawal of foreign investors from India.

Crude Oil, US Yields and Rupee Remain Critical

Near-term FII behaviour is likely to remain sensitive to global macroeconomic variables.

Higher US bond yields can make dollar-denominated assets relatively more attractive, while a stronger dollar can increase currency risks for investors holding Indian equities. Higher crude prices are another concern because India remains heavily dependent on imported oil.

Recent FPI selling has coincided with precisely these factors. Business Standard reported that higher US rates and yields, elevated crude prices, geopolitical tensions and a weaker rupee were among the factors behind September's renewed selling.

A more stable global rate environment, softer oil prices and reduced geopolitical uncertainty could therefore improve the near-term backdrop for foreign flows.

Primary Market Shows a Different Picture

Interestingly, foreign investors have not completely abandoned Indian equities.

While FPIs have been selling in the secondary market, they have continued to participate in primary-market opportunities. Business Standard reported that FPI primary-market investment remained positive in September, with ₹2,703 crore invested during the month as of the latest reported data.

This distinction is important. It indicates that foreign capital can still be attracted when investors see specific companies, IPOs or business models offering an attractive opportunity, even while their broader secondary-market allocation remains cautious.

Trading Return Could Come Before Investment Return

The key message from Bernstein is that the return of foreign capital may not happen in one step.

FIIs could first return tactically to trade Indian equities when market conditions become favourable. A sustained structural allocation would require a stronger combination of earnings growth, competitive businesses, reasonable valuations, adequate liquidity and globally scalable opportunities.

This creates the possibility of a market where foreign flows remain volatile rather than returning immediately to the strong, persistent inflow pattern seen during earlier phases of India's growth story.

What Could Change the FII Narrative?

Several developments could alter the foreign-investor equation over the coming quarters.

A moderation in crude prices could reduce pressure on India's inflation and external balance. Lower global bond yields could improve the relative attractiveness of emerging-market equities. A more stable rupee could also reduce currency-related concerns for dollar-based investors.

On the corporate side, stronger earnings growth and greater capital expenditure in emerging industries could provide a more compelling long-term investment case.

The development of globally competitive businesses in areas such as semiconductors, batteries, renewable energy, technology and advanced manufacturing could be particularly important if India wants to attract structural foreign allocations rather than short-term trading capital.

Market Outlook

Bernstein's assessment suggests that the question is not simply whether FIIs will return to Indian equities, but what kind of foreign capital returns first.

Over the next 12 months, the brokerage expects FII flows to be flat to modestly positive, while noting that a deeper structural revival would depend on improvements in India's long-term investment proposition.

For investors, institutional flows will remain an important market variable, but they need to be viewed alongside earnings growth, valuations, crude oil prices, global bond yields, the rupee and geopolitical developments.

India's domestic investor base has become considerably stronger, providing an important counterbalance to foreign selling. However, a sustained return of global capital would likely require more than improving market sentiment. Bernstein's analysis points towards the importance of building businesses and industries capable of competing globally and generating scalable growth.

The immediate market picture remains fluid. FPIs were net buyers of ₹599.54 crore on September 18, while DIIs bought ₹1,019.69 crore, demonstrating that foreign flows can turn positive even within a broader period of volatility.

The coming quarters will therefore be important in determining whether recent foreign participation represents tactical trading activity or the beginning of a more durable shift in global allocation towards Indian equities.