Do we need to invest in international mutual funds?

Published: October 13, 2021 at 7:04 am

Last Updated on October 13, 2021 at 7:04 am

Chitra asks, “Dear Pattu Sir, I have just started my mutual fund investment journey with a SIP in UTI Nifty index fund. I see many investors talk about Nasdaq 100 or S&P 500 funds, but I feel that they are not necessary. Can you please an article about this topic?”

The short answer to, “do we need international mutual funds in our portfolio?” is, no, they are not necessary. It is a choice, and we must be aware of the pros and cons before deciding.

Why do we take on capital market risk? The bare minimum goal is to try and achieve an overall portfolio return (fixed income + equity)  that keeps pace with inflation after tax by the time we need the money.

Will a good amount (50-60%) of Indian equity achieve this “over the long term”? There is a reasonable chance that it will. A reasonable chance (not a guarantee) is more than what most choices in life offer. See: Why should I invest in equity mutual funds when there is no guarantee of returns?

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The usual diplomatic recommendation of “have 10-20% of international equity funds” would still rely a fair bit on Indian equity to deliver! So it is a reasonable argument to state, I will depend on Indian equity alone. This 10-20% exposure should be at the portfolio level and not at the asset class (equity) level.

With that said, there are advantages to holding international equity funds in a portfolio. However, most investors are unlikely to appreciate this advantage. The primary reason for geographic diversification is to reduce overall portfolio volatility.

You expect (in the ideal case) one countries equity to do well when another is not. This does happen occasionally, but today we live in such a connected world that a crisis is rarely localised. A significant fall in one country or even one business with an international footprint can trigger a fall in all national markets.

So once could argue if all the markets are going to crash together, where is the benefit in international diversification? This is indeed a reasonable belief for sticking with Indian equity.

Now let us answer some questions honestly. Why are you interested in international equity funds? Two words: recent performance. Diversification is merely lip service for most investors to account for their desire to get a slice of the performing pie.

There is nothing wrong with this, of course. Wanting a slice of goliaths like Google, Facebook etc., is both natural and prudent. We all desire high returns. The question is, how many of us are ready to face the consequences?

  1. We must be ready to pay at least 6-7% more tax on long term capital gains (if there are any!) on international equity funds, and this is without the Rs. one lakh tax-free limit.
  2. We must rebalance the portfolio from international equity funds to Indian equity funds or from international equity funds to fixed income or vice versa without worrying about taxes or exit loads.
  3. When the tide turns, and these international funds stop performing or if the Rupee does not devalue as fast one would expect it to, we must keep the faith and continue investing. Why? Because that is how diversification works! Not everything will (or should!)  perform at the same time!

From our experience, most investors just the returns in the name of diversification but are not ready to maintain the portfolio. They would rather look at notional returns every day instead of paying tax on diversification.

We, therefore, believe an international equity fund would increase clutter in most investment portfolios. Why? “Diversification” is only for those investors who can or wish to analyse the performance of their investment at the portfolio level. Most investors have a piece-meal approach to portfolio review, and hence it would only result in clutter.

Even in a portfolio with regular maintenance, a “small exposure” of 10% or 20% is unlike to make a big difference. Meaning you may have 40% returns in the last few years from the Nasdaq 100, but it matters little if that is just 10% of your portfolio.

How about investing in an Indian equity fund with international exposure but taxed like an equity fund? Again, this is unnecessary, and even if one invests, the exposure has to be significant.  This would then increase the fund manager risk (fund not performing well in future).

Also, see:

What about currency risk? The long term devaluation rate of the Ruppe wrt the dollar is only about 5-6%. And this is meaningful only if the underlying equity does well. I could be wrong, but I don’t expect too much difference in the long-term performance of Indian equity funds and international equity funds, considering taxes and expense ratios. I will post a detailed return comparison soon.

What about those in developed countries? Should they not invest in international equity? If there is evidence or they believe that local equity is unlikely to keep pace with inflation (for example, due to economic or political turmoil), then international diversification becomes mandatory. Turmoil is possible in India, too, but that little international exposure will not help hold up our portfolios!

In summary, international diversification comes with taxes and high maintenance. Only investors who can appreciate risk and reward at the portfolio level should invest in them (small exposures of 10-15% are of little use!). A simple Nifty or Sensex fund will get the job done for most investors, especially new investors.

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