Offshore Funds Opt for Synthetic Investments Amidst Mid-Cap Stock Rally
Investments by offshore funds into participatory notes (P-notes) have soared to their highest level in nearly seven years as foreign portfolio investors (FPIs) continue to pour money into India’s thriving mid- and small-cap stocks.
According to the latest data from the National Securities Depository Limited (NSDL), P-notes worth Rs 1.43 lakh crore were in circulation as of January 31, marking the highest figure since June 2017 when P-notes amounting to Rs 1.65 lakh crore had been issued.
Financial advisors specializing in FPI investments have indicated a significant appetite among offshore funds for Indian mid-cap stocks, which have witnessed substantial rallies in recent years. Over the past year alone, the BSE Midcap index has surged by 65%, outperforming the benchmark Sensex, which recorded a gain of 27%.
The bulk of these investments has been directed towards high-growth companies in sectors such as technology, green infrastructure, and consumption, according to industry insiders.
“There is growing interest among smaller foreign funds, particularly quant and hedge funds, to explore opportunities in India’s mid- and small-cap segments, where the potential for superior returns exists,” stated a custodian familiar with the matter. “Given that these funds typically operate with smaller capital bases compared to foreign banks, obtaining an FPI license from Sebi may not be feasible. Hence, they are turning to the P-notes route.”
P-notes are synthetic investments issued by institutions registered as FPIs with Sebi. These instruments enable traders to take positions without deploying the capital required for direct asset purchases or sales. They serve as an investment avenue for foreign funds seeking exposure to India without the regulatory obligations associated with direct registration. Experts note that acquiring an FPI license would entail increased compliance burdens and tax obligations in India, making the P-note route more attractive for smaller investments, as the actual shares are held by the P-note issuing FPI.
In the case of P-notes, the issuer procures the shares or derivative contracts desired by the investor and subsequently issues contract notes against these securities. Therefore, P-notes represent contractual agreements with Indian securities as their underlying assets.
The recent surge in P-note issuance reflects a resurgence in this asset class, which had been largely shunned by foreign funds in the past due to regulatory apprehensions. Regulators, including Sebi and the tax department, had tightened rules governing P-notes amid concerns regarding money laundering and confidentiality. At its peak in 2008, P-notes contributed up to 40% of total FPI inflows into India.
“In the past decade, investors had reservations about P-notes due to regulatory scrutiny. However, the landscape is evolving,” remarked a consultant from a leading consultancy firm catering to foreign investors. “Mandatory disclosure of beneficial owners and the absence of tax benefits for anonymous investments are diminishing the reluctance of foreign funds towards P-notes.”
P-notes, as a percentage of total FPI assets in terms of value, have been steadily increasing, currently accounting for 2.1-2.4% of total FPI assets in India, the highest since October 2020.
Until 2017, P-notes held a much larger market share, representing around 10% of FPI assets in India. However, in mid-2017, Sebi issued a circular prohibiting P-notes from engaging in unhedged derivative market positions in India. This restriction led to a significant decline in the popularity of P-notes in India, as offshore funds were no longer able to invest in Indian derivatives via P-notes for speculative purposes.
