Foreign institutional investor capital has been flooding back into India, with the country topping 11 major Asian markets by net inflows with $11.4 billion to date this year, according to Bloomberg data.

The rebound in sentiment is in line with several other Asian markets including South Korea, which had also previously suffered FII outflow on the back of a deteriorating global economic picture.

What is striking in India’s case is that the return of FII interest flies in the face of investor concerns about the General Anti-Avoidance Rule (GAAR), which was proposed by the nation’s finance ministry this March.

GAAR seeks to impose a 15% capital gains tax on investment gains made within a 12-month period if a transaction is deemed to involve avoidance through such avenues as the double tax agreement that India has signed with Mauritius.

Shortly after it was announced, industry bodies including the Asia Securities Industry & Financial Markets Association (Asifma) blamed GAAR for a drastic drop in FII net inflow to Rs8 billion ($144 million) in the month to April 16, from Rs437 billion in the first three months.

Some foreign investors including hedge funds had opted to stop investing in Indian equities because of what they saw as an unquantifiable tax liability in running funds with Indian exposure.

Yet the GAAR issue remains unresolved today, and in June, India was the 10th best-performing stock market globally, according to Credit Suisse and Bloomberg. So what has fuelled this rally?

Heads of equity sales trading say it is a combination of investors buying into Indian stocks for index-tracking funds, and active emerging market fund managers taking positive views on particular sectors.

Robert Musetti, BNP’s global head of institutional sales for cash equity and derivatives for Asia-Pacific, reckons it can be put down to investors generally feeling better about risk and cyclical growth in the world compared with the trough of confidence seen during early summer.

“Policy risks related with the prospect of Greece falling out of the eurozone, and the [uncertainty related to] Spain over its plan to recapitalise its troubled banks dented confidence back then,” he says.  

Traditionally, FIIs have been more active in index options, index futures and single stock futures rather than cash equities, where flows are largely driven by retail investors.

But one head of Asia derivatives, who oversees listed options and futures business in India, says net FII inflow into India has been driven by dealers creating units of offshore-listed ETFs tracking indices with India exposure.

“These [FII] flows are mainly driven by volume in cash equities related to offshore ETFs with India exposure, where the dealer would hedge their short ETF exposure to the client by buying the underlying stock basket,” he says.

“Such interests in India-exposed ETFs is related to asset-allocation trades by investors, where India appears to be a beneficiary of flows rotating out of China partly due to concerns about its economic slowdown.”

The Singapore-listed iShares MSCI India Index ETF, which tracks the MSCI India Index, and the WisdomTree India Earnings Fund listed on NYSE Arca (an electronic trading venue owned by NYSE Euronext) have both seen pick-ups in outstanding shares since June.

But such increases have only been seen among select offshore ETFs and are yet to become broad-based.

Instead, one head of equity execution at a bank in Hong Kong sees money coming from global emerging market funds focused on sectors where active managers are putting money to work. He says financials and consumer-related stocks have been actively traded in the past two months.