Every pink paper worth its colour has been expending vast amounts of ink trying to tell readers about participatory notes. In the process, they’ve managed to stir up an infinite amount of confusion in the minds of retail investors.

What are participatory notes or P-notes? And why are they causing so much market movement? Do the Securities and Exchange Board of India (Sebi) regulations really matter to you? Here’s what it’s all about.

What are P-notes?

P-notes are instruments used by foreign funds, foreign institutional investors (FIIs) and investors, such as hedge funds who are not registered with Sebi but are interested in exposure to Indian securities. These foreign, un-registered investors place their orders through associates of India-based foreign brokerages, which have Mauritiusbased FII accounts.

The brokerages trade on behalf of their clients and then repatriate the dividends and capital gains to these entities. Simply put, the broker acts like a stock exchange, executing the trade and using its internal accounts to settle the trade. Through all this, the foreign investor remains anonymous.

Why are P-notes important?

According to Sebi estimates, the total foreign stake in Indian companies in August 2007 was around Rs 6.9 lakh crore, of which Rs 3.53 lakh crore (51.6% of the AUC or assets under custody) is through Pnotes.

This is an amazing 11% growth compared to the outstanding P-notes of Rs 31,875 crore (20% of total AUC) in March 2004. That’s definitely not small money. And now Sebi wants to know the identity of these financial entities, to ensure that organisations with questionable credentials do not participate in the market.

It works like this: when P-notes are first sold, they are sold to someone Sebi knows, but then they are sold in the market and can be, and are, purchased by people or institutions that Sebi does not know. These buyers do not have to be registered with Sebi or any other body. They can participate in the Indian bourses using FIIs as intermediaries. But since they are essentially faceless, Sebi will never know who these investors are.

Why do P-notes hurt markets?

The main issue or danger regarding P-notes is that they are dominated by hedge funds. These funds have only one objective—to make lots of money in a short time. It’s not a bad objective, and most small investors want to do the same thing.

However, the key difference is that hedge funds can move a market to their whims while small investors cannot, so there are times that their objective can go counter to what the regulator would like.

What is likely to happen now?

We have already seen the worst, when the markets tanked and then rebounded. It is also unlikely that FII inflows will be as unrestrained as in the past few months, given that outstanding P-notes account for over 51% of the foreign money in Indian markets.

Now that Sebi has ruled that P-notes with underlying derivatives have to be withdrawn in 18 months, it is likely that there may be some choppy sessions ahead. However, this is unlikely to have a long-lasting effect, because derivative-based P-notes are highly leveraged—something that contributes to volatility.

Hedge funds, which have been largely responsible for this rise in the market, might exit because Sebi will never let them register as FIIs. This will also mean that the appreciation pressure on the rupee will slacken to a large extent.

What will institutional investors do?

There are four categories of stock market players—FIIs, Indian institutions (mutual funds and insurers), operators and retail investors. The institutions are the largest players and market-makers; their actions determine market direction. The operators try to make a quick buck by staying one step ahead of institutions.

As a retail investor, what should you do? You have the least resources and the least access to information. However, you do have one huge advantage. Your money is your own. You can afford to take a long-term view because you don't have to report quarterly earnings. The stock market usually delivers best returns to the patient investor.

The last few weeks have been very volatile, with the market hitting unprecedented highs, then collapsing and now going through a recovery. Does this create a buying opportunity for you or is it a danger signal? If you want a quick buck, this is a dangerous market, as it might drop again in the short run.

But the long-term pattern seems quite clear. Everything, including institutional attitude, suggests that the bull market will continue. We’ve seen a pattern where GDP growth of 6.5% has translated into corporate earnings growth of about 29% per annum in the past five years. The stock market indices have gained 40% per annum in the same period.

The big picture

In the next five years, investment opportunities will zoom. The Planning Commission has outlined an ambitious XI Plan, which envisages a total overhaul of infrastructure. Newly planned projects will need another $500 billion or more in investments. The Commission expects at least 30% of such investments to come from the private sector.

This means many more highquality IPOs and spins-offs for heavy industries such as construction, cement, steel and engineering. There is consensus that the GDP will continue to grow at current rates (8% plus) or better.

Logically, the stock market can go only up in the long term. If the growth rates of the past five years are maintained, and all the smart money is betting that they will, the next five years should prove to be equally good.