The rebound in the Indian stock market is pushing up the weight of the MSCI Emerging Markets Index, putting global fund managers in a dilemma: either sit back and watch their relative exposure shrink, or buy in at increasingly outrageous prices. Most people think the latter carries a great deal of risk and are looking for alternative options, with some putting their money into smaller Indian companies and others turning their attention to other emerging markets.

This trend has been driven by India's strong profits over the years, while the weight of the Indian stock market in the MSCI Emerging Markets Index, which serves as a benchmark for global emerging market funds, is rising. India's weight in the MSCI Emerging Markets has soared from 8% four years ago to the current 19%, and analysts at Nuvama Alternative & Quantitative Research predict that it will exceed 22% by the end of this year.

One reason for reducing holdings in the Indian stock market is that other markets are cheaper and more dynamic, and the cost of entering and exiting funds in India may be high.

Fund managers need to quickly buy Indian company stocks to keep up with their growing influence in the index. According to data from LSEG, the average price-to-earnings ratio of large and medium-sized Indian companies is 24 times, making it the most expensive among major markets. In comparison, blue-chip stocks in China have much lower valuations, with the same price-to-earnings ratio of 17 times, and large-cap stocks in Malaysia have a price-to-earnings ratio of 15 times.

According to data from HSBC and Copley Fund Research, many funds have chosen not to buy, making India the country with the largest percentage of holdings reduction in emerging market funds. For example, for Gary Tan, portfolio manager of Allspring Global Investments, and his clients, valuation is the key issue, and he has been reducing his holdings in Indian stocks for the past few years. Tan said, "We are optimistic about the long-term prospects, but very cautious about valuation levels."

For a long time, the valuation of the Indian stock market has been relatively high, outperforming the global market. Now some investors are becoming cautious about the risk-return balance. Since mid-2020, the Indian Nifty 50 index has risen by 145%, the S&P India Sensex index has skyrocketed by 136%, while the S&P 500 index has risen by 78% over the same period.

However, despite foreign investors being consistent buyers of Indian stocks this year and in 2023, there is now a shift in capital flow and investor sentiment. Data from ICICI Securities shows that foreign investments in Indian mid-cap and small-cap companies outweigh those in large-cap stocks in the first half of this year. And exchange data for August shows that foreign investors sold $0.662 billion worth of stocks. According to ICICI Securities, foreign investors currently hold approximately 16% of Indian stocks, the lowest level in 10 years.

It is certain that a large number of bulls and funds are flowing in, and these funds are not based on emerging market indices. Howie Schwab, portfolio manager of Driehaus Capital's emerging market growth, said that global investors' interest in India is growing, not just investors who do business in emerging markets.

Vivian Lin Thurston, portfolio manager of William Blair's emerging market growth strategy, said that valuation alone is not necessarily enough reason for investors to shift to other markets. She said, "If I sell India, do I have other attractive investment opportunities? Currently, the answer is not many, and that's a problem I'm trying to solve."

However, the inflow of funds into the Malaysian and Indonesian markets indicates that investors are now starting to look elsewhere. Meanwhile, foreign investors are selling expensive Indian secondary market stocks and turning to primary market IPOs in search of lower investment costs and higher returns.

A report from Indebank shows that foreign investors have purchased over $6 billion worth of stocks in the Indian primary market this year, the highest level since 2021. Rajat Agarwal, SG's Asia stock strategist, said, "Foreign investors are unwilling to commit their funds to the secondary market for the long term. They see better and faster return prospects in the primary market. They have become sellers in the secondary market this year, partly because of the slowdown in profit growth."

In contrast, foreign investors are attracted to inexpensive stocks in the Indian primary market. Jon Withaar, Head of Baring Asian Special Situations at Baring Asset Management, said that valuations in the primary market are often lower due to a lack of competition from retail investors, indices, ETFs, and many types of institutional investors.

James Cook, Global Head of Emerging Market Investments at Federated Hermes, said, "India's economic growth is not a secret. When you have this kind of consensus and the outlook seems benign, investors may fall into the trap of ignoring any potential pitfalls, such as paying too high a price to enter the market." He is reducing his holdings of Indian stocks and waiting to buy more after the price drops.