Investing in other countries is a good thing especially while considering the greater picture of Diversification. The bigger a portfolio gets greater the need for diversification. All the big wealth management houses will be making sales pitches regarding the importance of diversification and why we need exposures to other countries.
Diversification is important and in this post I am not criticizing the need for diversification, I just want to dig a bit deeper in elucidating that just because you invest in some other country does not mean you are diversifying your portfolio.
Let’s drill down a bit deeper into understanding what diversification is and why do wealth managers advice not to put all your eggs in one basket. The rationale behind diversification technique is that a portfolio of different kinds of investments will, on average, yield higher returns (research done by Fidelity international) and pose a lower risk than any individual investment found within the portfolio. Typical case would be when stock markets underperform people do shift their focus to bond funds or real estate to protect their wealth. The pioneer in the theory of portfolio diversification is Markowitz, his theory of portfolio diversification proves that combining an asset that has negative or low correlation with other assets in a portfolio provides superior risk-adjusted returns.
Diversification actually tries to even out a portfolios return or to that effect reduce the impact of any unexpected risk events that could derail the investment theme. In a well diversified portfolio positive performance of some investments will neutralize the negative performance of others. This can be achieved only if the Investments are negatively correlated. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated. Example gold investment exposure in a portfolio would have reduced the losses incurred in the equity portfolio during 2008-2009.
For the Inquisitive Investor
When DSP Blackrock Mutual Fund went about thumping its chest about the DSP Blackrock World Gold fund, all and sundry investment advisors went behind them stating that the fund is a perfect insulation from an underperforming equity market. The actual case was exactly the opposite.
When the stock markets collapsed the fund also hit its bottom. The fund was exposed to GOLD (Gold has a negative correlation with stock market performance) but the scheme had investments in stocks of gold mining companies and hence even though the fundamentals of the companies looked good during the recession and the price of gold went up, the stock market collapse took down the shares of the gold mining companies along with it. This shows how careful we need to be in understanding the nuances of diversification. The fund lost 60% from its peak NAV during the recession.
On the same note there has always been a set of advisors pushing investors to invest in offshore funds or funds with exposures to other countries and not only in India. Diversification is good here it is not necessary that all countries will collapse at the same time and even if Europe collapses it is not necessary India will follow or for that matter Brazil, US, & China all seem to be safe haven for Investments. Emerging economies like India, Indonesia, and Malaysia are currently one of the most talked about markets from an Investment point of view.
In the US most Investment analyst and broking houses are advising clients to move anywhere between 10-50% of their portfolio’s to emerging market stocks.
What did we learn there should be a perfect or at least a negative correlation for two different asset classes then only diversification will make sense.
This post is mainly to make you aware that investing into Asian economies will not serve the purpose of diversification. Time and again I keep reading articles in different finance journals and papers about the benefit of offshore investing, I am not condemning offshore investment the point is where the investments are… if you are going to invest in someplace where the market dynamics follow India then it doesn’t serve the purpose. The cost of investing outside the country is also much higher. The second point I want to stress is the current international funds on offer are not as diversified as you think and most of them have only an exposure of 30% to other countries. In this post I will also try to throw some light on International Funds floated by Indian Mutual fund Houses.
What are international funds?
International funds are funds that invest in global markets. An example would be Franklin Asian equity Fund, the Fund invest 30% of its portfolio to buy stocks from markets like china, Singapore, Korea and Taiwan.
What are the types of International Funds?
From an Indian Investor perspective you can classify them on the basis of Taxation
Equity Taxation
Debt Taxation
Funds with Equity taxation must have a minimum allocation of 65% to Indian Stocks, and the funds with debt taxation can invest even their entire amount in foreign stocks.
What are the Risk Involved in International Funds?
Country Risk – Obviously if tomorrow a Dubai kind of situation happens or Spain, Portugal, Greece kind of situation happens then yes you have lost your money and that can happen even in India. So let’s not discuss that as these events are difficult to predict and it becomes very difficult in analyzing country balance sheets as there is a mass of hidden data. So assuming you made investments into china thinking why put all eggs in one basket and then tomorrow china stock market collapses due to a real estate bubble you have lost your money.
Currency Risk – if the country you invest in assuming china suddenly devalues its currency and the rupee appreciates vis-à-vis ‘Yuan’. Then you capital will take a beating. So currency movements can positively and negatively hit your holdings…
Example; you invested Rs 100,000 in ‘Mirae China Fund’ the fund buys china stocks hence your 1lak is converted into YUAN to invest in CHINA. Assuming 1 Yuan is 10Rs then you have 10,000 Yuan. The stock market goes up by 10% and hence your 10000 yuan becomes 11000. You decide to pull out the money for a foreign trip.
Now assume the Ruppe appreciated by 20% vis-à-vis Yuan then the currency rate becomes 1 yuan = 8Rs. When you convert your 11000 yuan you get only (11000*8) Rs.88,000 in your hand. Even if the investments are up, due to rupee appreciation the gain made is wiped out, the reverse is also true if the rupee had depreciated by 20%, then the net returns in the hand of the investor would have been…(11000*12) Rs132,000.
Global Capital Movement – most sites will talk about the above two risk mentioned but the major risk for me is global capital flows. In my analysis I have found that the correlation of stock market movement in Asian countries is much higher when compared to similar movements in European countries.
There are large fund holdings like ETF’s and hedge funds which move across counties creating asset bubbles across the world. They basically follow a herd mentality, when a famous US analyst puts out a buy recommendation on emerging countries money flows into Emerging market Index. This money in turn gets invested into the respective domestic stock exchanges. Which gives a relatively linear movement, this is against the diversification rule.
I find that Asian stock markets move in tandem with Indian stock market so the basic premise of Investing in International fund which predominantly holds Asian stocks is absurd.
If you scan economic articles on Asian markets there are papers submitted by experts stating the coexistence of Asian markets. If you think I am pulling data from the air then I would suggest all inquisitive Investors to do a co-integration and error-correction method using closing price of various indices with volume movement to understand that the price indices of the five markets are co-integrated. The existence of a linear combination of the five indices forces these indices to have a long-term equilibrium relationship implies that the indices are perfectly correlated in the long run and diversification among these five equity markets cannot benefit international portfolio investors. However, there can be excess returns in the short run which could happen due to micro factors affecting the domestic market like higher IIP number or GDP growth rate, improved exports.
In the Chart you will see the returns on QoQ basis for the last 2 years the difference in performance is not that great an ordinary funds like HDFC top 200 has outperformed the international funds by a huge margin. The close contenders like ICICI Asia equity Fund & Templeton have 65% of their exposure to Indian markets.
International Funds – A brief
India has about 27 international funds this includes funds that have invested into commodities as well a detailed discussion on each one of them will follow thru at later post. Out of the 27 at least 23 have a track record in excess of 1 year which would make it easy to understand and analyze their performance.
As of Nov we have about 22000Cr exposure to International funds but since most funds have an exposure of only 30% to foreign equities the actual investments is quite small. As percentage we have about Rs 2,20,000 Cr exposure to equities and our percentage exposure to foreign stocks is around 3%. My problem is not with foreign exposure but the countries we are choosing for our exposure.
Any way I am not going to comment on the individual schemes and I leave it to you to decide what is good or bad, I just wanted to throw some light on the coexistence or the linear movement of Asian markets. There are some schemes like Fidelity global assets & Templeton India Equity income fund which have delivered significant alpha. I have not done analysis on these or individually checked for their correlation but on risk return basis they are a doing well.
If you ask me for a hedge against Indian Equity, I have strong feelings for China (stock specific), Commodities Investment and Europe & US.
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