FUND FLAVOUR

April 2018

“Risk comes from not knowing what you’re doing” – Warren Buffet.

These famous words could have been about Global/International Funds, funds that add an element of geographical diversification. A global fund primarily invests in markets across the world, including those in the own country of the investor. An international fund, on the other hand, has no investment in the home country of an investor, with all funds concentrated in global/international markets. In the case of an Indian investor, an international mutual fund would be a fund that invests in the equities of companies that are outside India. However, this is not for lazy or passive investors. International funds require careful and continual market research. The investor should be sure of his investment goals, both short-term and long-term, before venturing in. Check vintage and track records that will help you zero in on a fund that suits your sensibilities.

International mutual funds come in three types…

Domestic-International Hybrid: The domestic-international hybrid fund invests 65 per cent plus money in domestic equities and the balance around 35 per cent in international markets. In the case of the Indian investors, this is a good option because Indian markets are doing rather well presently and the road map for future looks good. 

Feeder Investments: These funds invest through “feeder” route into a particular country or region. Under this mechanism, the fund invests in another international fund, which in turn invests directly in foreign stocks.

Thematic Investments: These funds invest in stocks with an underlying theme based on sector and industry.

Rationale for International Mutual Funds

Investing in a global fund can be a smart move, provided one knows the basics of this fund. Individuals looking to diversify their portfolio, aiming to have multiple markets through which they can earn a profit might be suited for this fund. Smart investors have always been lured towards overseas funds for umpteen reasons. One, as you know, is diversification. Two, economic cycle varies for different countries, and simultaneous investment in different economies ensures minimal loss and possibly, smoother returns. Three, exposure to international markets can only broaden your experience and expertise.

The pros…

The biggest advantage of investing in international funds is diversification benefits. By adding international funds to your portfolio, you can reduce the overall volatility of your portfolio by as much as 5-10%. The primary reason for this is the co-relation of the domestic markets is lower with international markets, especially with that of developed markets. 

Another advantage is ability to take exposure to sectors or companies that you would ordinarily not have exposure to. Global companies like Amazon, Google, Facebook, Coca Cola, etc. are widely known and used brands in India; they derive a fair share of the revenues/users from countries such as ours. By investing in these funds, you can potentially gain exposure to such stocks. 

An international fund acts as a hedge against the fall in the rupee against dollar, thus minimising loss owing to the currency depreciation. 

Majority of the international mutual fund schemes have commendable reputation and provide adequate data on their past performance. All of this information empowers the investors to take a sound and informed decision. 

An investor has wide variety of schemes at his/her disposal. The investor can choose region-specific schemes or schemes based on particular theme. 

The cons…

The Indian economy is a bright spot for investment and it is one of the prominent economies among all emerging markets, investments made in the Indian markets have delivered hefty returns, while international economies are facing slowdown and some economies have reached stagnation point. In such a scenario, investing in low growth foreign funds instead of investing in the prominent economies of the emerging markets needs a careful consideration. 

One of the risks associated with investing in international funds is currency risk. If rupee strengthens, then it erodes your returns vis-à-vis a pure domestic investment. Also, if you are investing into country or region-specific funds, then you could be exposed to specific country/geopolitical risks. 

Another aspect, though not a risk, is the unfavourable tax treatment for international equity funds. Although these are equity funds, for tax purposes they are classified as non-equity, thus investors end up paying a capital gains tax which is higher compared to domestic equity funds.

Investments made in foreign funds are exposed to geopolitical risks, i.e. these are likely to suffer from political disturbances in the country or region in which investments are made. Keeping abreast of such developments is not easy for retail investors. By the time a retail investor decides to withdraw in panic to avoid losses, it might be too late.

Parameters prior to investment

There are a few things to consider while taking international fund exposure. Firstly, each investor needs to understand their risk and return requirements, basis their investment objectives and time horizon. Once these have been arrived at, an efficient portfolio is constructed, which decides the level of international fund allocations. The next decision would involve choosing the types of international exposure – country specific, regional, emerging markets, developed markets, etc. Most investors would be better-served taking exposure to developed markets funds or funds investing into the US or Europe, which are more broad-based.

Participation…

International funds from an Indian investor’s perspective have been a little bit of a hit-and-miss. Global fund investment options, albeit limited, have been around for a decade, with options to invest into the US, Europe, ASEAN, country-specific funds like Brazil and China and even funds investing into natural resources companies like gold mining companies or energy companies. The greatest amount of investor interest has typically been in gold mining funds and the US funds. In fact, in 2013, when the Indian equity markets were going through a prolonged lull phase, domestic equity funds too were witnessing stagnating growth. At the time, investors increased allocation into the US funds on the back of strong one year historical returns of these funds. Post that, though the story has been very different, with the start of the domestic equity market rally in 2014, domestic fund flows are reaching new highs, but global funds are witnessing a slow trickle of redemptions. As an effect of this, global funds currently form a minuscule proportion of investor’s equity portfolio at 0.27% from a high of 1.56% in Jan 2014. 

Performance & drivers…

Since the global funds available are quite diverse, we have compared the returns of some of the popular global indices with the Nifty. This gives you an idea that no one index/country can consistently outperform year-on-year. In fact, the returns can be quite divergent. The one-year, three-year, five-year and ten-year returns of international funds are 14.47%, 6.47%, 6.48% and 2.37% respectively. Understandably, the performances of International Funds have varied wildly depending upon the timeframe, theme, and geography in question. For instance - the NAV of Kotak World Gold Fund, a feeder fund into Falcon Gold Equity Fund, has dropped by 19.08per cent in the past year, whereas Mirae China Advantage Fund has delivered stellar returns of over 26per cent in the same period. However - a 3-year timeframe tells us a different story. Of the 60 international funds with a 3-year plus track record, only two have provided double digit annualized returns. As many as 23 funds have delivered a negative 3-year CAGR. Investors who are considering investing into International Funds need to bear in mind that they have a unique set of risks intrinsic to them. First, there's the risk of the target country's currency depreciating during your investment timeframe, leading to an equivalent loss in the rupee value of your units. Second, there's the risk of the fund's target country itself underperforming. Together, these two risks can potentially create a double whammy effect on returns. A case in point is the beleaguered HSBC Brazil Fund, which has delivered a 5-year annualized return of -7.26per cent.

Why International Funds warrant a place in your portfolio

Despite their risks, we believe that International Funds do warrant a place in your portfolio at this time. Valuation-wise, Indian equities are not exactly cheap anymore, and various signs are pointing to the fact that we may already be in the mid-stages of the current bull-run. A smartly selected International Fund can help balance out the risk in your portfolio by hedging you against a fall in the Rupee versus the Dollar, and by strapping on an additional layer of diversification outside of Indian assets. Additionally, some mature markets such as the U.S are generally more stable and trade at 3-4X lower earnings multiples than domestic indices; they can help stabilize your equity portfolio and smooth out your long-term returns.

The Bottom Line

Selecting the right International Fund portfolio can be a tricky task, and new investors with modest portfolios should ideally steer clear of them and opt for SIPs in domestic equity funds instead. Chasing historical returns or shying away from an International Fund based on past returns can both end up backfiring. At the very least, novice investors should avoid the second and third categories of International Funds, while making small & incremental investments into the first kind that combine domestic and international equities in a tax-efficient manner. If you are a savvier investor with a keen understanding of how domestic and global equity markets work, you could consider a 10-15 per cent allocation to International Funds. Chinese Funds, despite their stellar one-year returns, may have become too risky for comfort at this point. U.S is still considered well balanced in terms of risk and reward, whereas Japanese markets hold potential, with the country having implemented a three-pronged strategy for economic growth; comprising of fiscal stimulus, monetary easing and structural reforms. Use International Funds as a supplement to your core portfolio of domestic funds. Don't go overboard in your allocation to them. In all fairness, we will always be privier to market influencers that are closer home.