International mutual funds: Should I invest in them?

Each time investors recognise that the Indian stock market will not always keep moving up, they start asking, “should I include international mutual funds in my portfolio for diversification?” This is not a “yes/no” question and like practically all questions in personal finance, is best answered with a question: If you invest in international mutual funds are you ready to appreciate pros and cons and actively manage your portfolio suitably?

Sadly, investors look at the US market rising when the Indian markets are swinging sideways and assume “some exposure” to US stocks/ETFs will help them get a better return. Wanting a “piece of the action” is neither diversification, not risk management. Let us go over this step by step.

How much international equity exposure would make a difference in my portfolio? If you truly understand the answer to this question, the issue of whether to hold such stocks or funds will be settled once and for all. Let us consider a familiar creature: the aggressive hybrid fund or what was previously known simply as balanced funds.

These must hold at least 65% of Indian equity, and typically there is little or no arbitrage involved. Meaning almost at all times, they contain at least 25% (usually 30%) of bonds.  The portfolio is rebalanced to said asset allocation once a month – something a retail investor would never do independently.

Now consider the returns made by large cap funds in 2008. The highest return (or lowest loss) was -45%. In the aggressive hybrid category, it was -36%.

25-30% bond exposure (regularly rebalanced) helped reduce losses due to a global market crash by 20%

There are two lessons here: (1) If you want international equity to make a difference in your equity portfolio a little exposure (read 5-10%) will neither soften market blows significantly nor will it boost returns (as the tax rate is higher). You need at least 20-30% exposure.  (2) Such exposure should not be left alone. If Indian equity shines, and international equity does not, you should be ready to rebalance.

For example, suppose you start with 40% bonds, 35% Indian equity and 25% international fund and after three years the allocation changes to 39% bonds, 41% Indian equity and 19% foreign equity, will you rebalance or wait for it “recover”. Most investors fearing tax will not. Such an approach will negate the benefits of such diversification.

Also, international equity exposure should be mean genuinely international exposure, not just US or European or Chinese equity, etc.!! It has to be genuinely diversified across developed markets and emerging markets. I had earlier identified two such funds:

1. Edelweiss Emerging Markets Opportunities Equity Offshore Fund (4.4% return since July 2014, inception)
2. Invesco India Feeder- Invesco Global Equity Income Fund (4% return since May 2014, inception)

Are you ready for true international diversification, or do you want a piece of the currently tasty pie without understanding implications? Don’t you think you would have done better with safe Indian fixed income like an FD or RD?

As long as we have small savings schemes not affected by the capital markets, there is no need for international mutual funds or gold in the portfolio. Most investors do not understand the basics of managing such portfolios and are better off without such exposure.

Those who claim gold or international equity will offer better diversification should also quantify such statements with their portfolios. Such quantification is not hard but will take some effort. Causal investing is a waste of time.

Check out: My Handpicked Mutual Funds July 2019 (PlumbLine)

Disclosure: I hold PPFAS Long Term Value Fund. Currently (June 2019), it contains about 20.3% of US stocks, another 8.6% from elsewhere (Japan, Switzerland), so a total of  27.82%.  Since this is about 32% of my retirement portfolio, my effective international exposure is only about 9%, which is next to nothing. I like PPFAS because of its lower volatility. When the US markets crash, I think the fund will be tested. So do not jump in unless you are mentally prepared.