Investing through Domestic Institutional Investors (DIIs), such as mutual funds, insurance companies, and pension funds in India, can carry certain risks when held for the very long term, particularly in scenarios where Foreign Institutional Investors (FIIs) are consistently exiting the market. This dynamic has been evident in the Indian stock market in 2025, where FII outflows have been significant, often countered by DII inflows. Below, we will break down the key reasons why this can be dangerous, based on market analyses and reports. These risks stem from structural, economic, and behavioral factors rather than any inherent flaw in DIIs themselves.

(1) Potential For Unsustainable Market Support: DIIs often act as a buffer by buying stocks when FIIs sell, preventing immediate crashes and providing short-term stability. However, this “propping up” is not always sustainable over the long term. DII inflows largely come from domestic retail savings (e.g., via SIPs in mutual funds). If prolonged FII exits lead to market downturns, retail investors may panic and redeem their holdings, forcing DIIs to sell assets at a loss. This creates a vicious cycle of amplified selling pressure, eroding long-term portfolio values.

For example, in early 2025, DIIs injected over ₹1.2 lakh crore to offset FII withdrawals of ₹1.5 lakh crore, neutralising much of the impact on large-cap indices. But if redemptions spike due to volatility, DIIs could turn from buyers to sellers, exacerbating declines.

(2) Risk Of Overvalued Markets And Bubble Formation: When FIIs exit en masse—often due to high Indian valuations, global interest rate hikes, or shifts to safer assets like U.S. treasuries—the market may be left overpriced. DIIs continuing to invest can mask these issues, inflating a bubble that bursts over time. Long-term holders (e.g., in DII-managed funds) face the danger of sharp corrections when reality sets in, such as economic slowdowns or global recessions.

For example, FIIs have cited India’s high valuations and better risk-adjusted returns elsewhere (e.g., China or US bonds at 4-5% yields) as reasons for leaving. This leaves behind “overpriced assets in a high-risk market,” signaling potential long-term economic concerns.

(3) Reduced Market Liquidity And Exit Challenges: FIIs provide significant liquidity to the Indian market through their large-scale trading. Their prolonged exits reduce overall market depth, making it harder to buy or sell stocks without significant price impacts. For long-term DII investments, this means positions could become illiquid during stress periods, leading to forced sales at unfavorable prices or prolonged underperformance.

For example, FII holdings dropped to 16% of the market in 2024 from a peak of 20%, with continued selling reducing liquidity further. This makes the market more vulnerable to shocks, especially in mid- and small-cap segments, which saw over 20% plunges in 2025 despite DII support.

(4) Equity Supply Overhang And Limited Upside: Persistent FII selling, combined with increased IPOs, Offers for Sale (OFS), and promoter exits, creates a flood of equity supply. DII inflows may absorb this supply without driving meaningful price appreciation, capping long-term returns. In extreme cases, this leads to stagnant or declining valuations, eroding the benefits of long-term holding.

For example, 2024 saw record-high equity supply, which could absorb most DII inflows and limit market gains in the near to medium term. This “perfect storm” of DII surge, FII shuffle, and promoter exits reshapes ownership but heightens volatility risks.

(5) Broader Economic And Geopolitical Signals: FII exits often reflect deeper issues like geopolitical tensions, currency depreciation (e.g., rupee weakening 3% in 2024), or global risk aversion. Relying on DIIs ignores these warnings, potentially exposing long-term investments to systemic risks such as inflation, slower growth, or policy changes. While DIIs promote domestic stability, over-dependence can delay necessary market adjustments, leading to larger corrections later.

In summary, while DIIs have reduced India’s dependence on FII inflows and provided a counterbalance (e.g., holding market stability despite $800 billion in FII equity exposure), long-term reliance on them amid FII exits can lead to hidden vulnerabilities. Investors should diversify, monitor fundamentals, and not assume DII support is indefinite.