Today, we live in a highly interconnected global world. For any company, geography is no longer a restriction to market expansion. The time taken for any product or service to traverse the globe is shrinking with every passing year. In fact, when you think of it we all end up contributing to the revenues and profits of such global companies daily. Be it through the ads we consume on Facebook or the PDF reader we install on our laptops or even the coveted Nike sports shoes we end up buying with the distant dream of the lockdown lifting someday.
Then it’s only logical that as investors, we should hold equity in these companies and participate in the wealth creation that is foreseen in their future. However, before you tick this off as a colloquial old-school reasoning, let’s look at five number-based facts which make it imperative for any investor to diversify their portfolio by allocating funds to foreign equity.
1. Low correlation to Indian Markets
One of the basic tenet of diversification within a portfolio is to invest in varied assets with low correlation to each other. For instance, the classic mix of debt and equity is recommended for the simple fact that over time they are often negatively correlated to each other. Although Indian and Foreign equities are not negatively correlated, the correlation is fairly low. There is a simple reason for that.
Indian markets still depend heavily on the flows coming in from Foreign Institutional Investors or FIIs. Most of them treat Emerging Markets and Home Markets as separate buckets. When they see the risk in Emerging Markets as higher than their comfort level, they generally reallocate that money back in the home market. Hence, at a time when Indian markets will see a dip is often when foreign equities will simultaneously zoom up on fresh infusion of liquidity.
Look at the chart below of the past decade and corresponding returns. This will give an idea of the movements that the markets undertake. For the purpose, we have taken the levels for Sensex and S&P 500 (the world’s largest and oldest index) on the first and the last trading day of each calendar year. As you will see, the markets move quite differently from each other.
2. Bigger piece of the world equity pie
India might be one of the fastest-growing economies, or at least was projected to be before this horrible, unprecedented second wave of coronavirus that has washed over us. However, in absolute terms, we still remain a minuscule part of the world equities market.
Of the $95 Trillion global market cap, the US accounts for the lion’s share with almost 56%. India, on the other hand with a market cap of $2.7 Trillion barely makes up 3% of the share. In fact, Apple alone with a market cap of $2.08 Trillion makes up 77% of our entire market cap! Add Amazon and Microsoft to this tally and these three companies end up with a cumulative market cap double of India.
Hence, as an Indian investor, it is imperative to invest in global companies which represent a far bigger chunk of the equities market.
3. Geographic diversification
A lot of the risk and volatility that equities experience are specific to the home country. Most equity markets are jittery before a big change like upcoming elections. However, those are specific to the country.
When an investor invests in foreign equity, this systemic risk of specific economies gets diversified as those companies depend on revenues from multiple countries. There are rare instances like the sub-prime crisis of 2008 or the coronavirus crisis of 2020 that impact the whole world at the same time. However, even at such instances, the timing of the recovery often varies, helping yet again with the diversification.
4. Currency hedge
While the base asset class that we invest in remains equity here, it comes with an in-built additional asset, that of currency. So, if an investor invests in a China based fund or even a US-heavy fund the depreciation of the Indian rupee adds in to the returns.
As per the long term historical trend, rupee has depreciated as compared to US Dollar by 4-5% per annum on an average. This feeds into the returns that foreign equity generates for Indian investors.
5. Sunrise sectors
However we might want to deny the fact, India remains a follower market. Hence, when we talk of innovation and disruptive sectors like food delivery, entertainment or even healthcare US leads the way. Even when it comes to those companies getting listed and creating wealth for investors, India follows with a lag of a few years.
For instance, we are still just getting used to the idea of a digital insurance provider like Digit. Whereas in the US, a similar company called Lemonade is already talk of the town and got listed last July. Even a company like Beyond Meat revolutionising the idea of lab-made meat is listed in the US.
Hence, if as an investor you want to get some share of the sunrise sectors early on, foreign equity becomes a necessary addition to your portfolio.
Equities or Mutual Funds?
While we will get to the possible option in Mutual Funds, we should address the question of buying foreign equity directly. In India, we still believe there is room for investing in a few bluechip stocks in addition to stable mutual funds to aid in wealth creation.
However, foreign equities are an unknown terrain especially while we sit and operate out of India. Ideally, it is a territory better left to professionals who are in the thick of things there. Not just that. Investment in foreign equity gets counted as part of the $250,000 LRS or remittance limit as the rupees get converted to the currency in question before purchasing a stock. The documentation and compliance would be as complex as well. On the other hand, mutual funds tend to be relatively hassle-free with all the professional management your money might need.
Options to invest in foreign equity mutual funds
Now that AMCs have seen some appetite among Indian investors to enter into foreign mutual funds, there are new options added to the mix almost everyday. However, these can be classified into four broad categories.
This is by far the most popular route. Essentially, AMCs in India either tie up with their global parent (in case it is a global AMC like Franklin, Invesco or Mirae) or have an agreement with an unconnected global asset management firm. The feeder fund in India might have a slightly different name and then the money invested into it flows directly into the underlying fund. However, the NAV is specific to India as it adds in the currency impact
For instance, Invesco India – Invesco Global Consumer Trends Fund of Fund as the name suggests, invests in the Invesco Global Consumer Trends fund. On the other hand, Edelweiss has tied up with JP Morgan for multiple opportunities including their Greater China fund and Emerging Market Opportunities fund.
Do note that there is a slightly higher cost structure for most of these funds as the management fees are shared by the actual fund management team as well as the Indian partner doing more of the logistics grunt work.
Actively managed foreign equity funds
While this is a minuscule category, there are a few fund houses in India which practice active management in global markets while sitting here. This includes funds like ICICI Prudential US Bluechip Equity Fund, Nippon India US Equity Fund, and Aditya Birla Sun Life International Equity Fund. These funds are generally cheaper in their cost structure as, unlike feeder funds, they do not have two stakeholders that need to be paid.
Passive investing by way of index funds is a much older and more mature strategy in developed markets. In India too, some AMCs offer the option to invest in the bigger global indices like S&P 500 and Nasdaq. Motilal Oswal has been particularly bullish about index funds and offers both these options. Kotak too has recently introduced a Nasdaq index fund. Mirae is the latest to join the bandwagon by introducing a tech-specific index through their FANG+ ETF.
Domestic foreign mix
This is one of the newest categories to hit the block. One of the first AMCs to come up with this idea was Parag Parikh mutual funds with their flexi cap fund. In this particular option, they ear mark a 30-35% allocation for foreign equity keeping the rest of the portfolio invested in the domestic market. The reason for it will be made clear when we discuss the taxation.
Today, a lot of AMCs have been dipping their toes with trying out this strategy. Axis Mutual Funds, thanks to their partnership with Schroders have three such funds now. As of March 2021 SBI Mutual Fund also had very miniscule allocations to foreign equity in three of their funds, thanks to the partnership with Amundi, a French investment firm. Kotak, with it’s Pioneer fund has also chalked out about 20% for foreign equity.
As these funds end up being better balanced with this mix, we see this trend only intensifying.
For the government, it makes sense to promote investments in direct equity. For this, they use a tool most under their control, albeit taxation.
Hence, foreign equity is taxed as per debt norms. Short term is considered as an investment period of fewer than 3 years, attracting tax on gains as per income tax bracket. On the other hand, long-term is an investing period of more than 3 years which means a flat 20% tax on post-indexation gains.
When it comes to hybrid funds, and with more than 65% allocation to domestic equity is tagged as equity for taxation purposes also. It is this regulation that is used by AMCs when they construct the domestic foreign mix funds, ensuring a minimum 65% to domestic equity while playing the global field with the remaining flexibility. As you can see, despite the pinching tax norms, it makes sense to have a 5-10% allocation to overseas mutual funds in your portfolio.