Diversification is a word that many investors use rather loosely. Whenever they seem something “offer good returns" I have seen many investors want a piece of that action and say “I have added it for diversification". Again that classic mistake. Choosing a product/security/asset class by looking at its (recent) returns and not its risk. People who wanted “some exposure" to bitcoins did not realise that it has seen sideways movement before and assumed that all it will do is “rise". This is the reason why investors have also flocked to Indian mutual funds – let us call it the “sahi hai mindset". I would wager that this is the reason why many resident Indians want “exposure to international stocks".
Well by “international", many actually mean US stocks. The question is, “is this necessary?" Let us dig deeper. This post is for resident Indians only. NRIs may or may not “have to" seek international securities depending on where they live. Before we begin a couple of announcements: First: Do check out yesterdays post in case you missed it: Lok Sabha Elections 2019: Worried about how markets will react? Here is a way out. I am trying to change hosting servers and I am not sure if everyone got to see it. Second I have started the Tamil version of Re-assemble a series of basic money management steps for beginners. Check out the first two steps on youtube. You can download the English e-book here.
So what is portfolio diversification? The idea is to choose asset classes that do not correlate well with each other. That is, if one fails, the other rises or at least maintains the status quo. We Indians are an entitled lot. The government offers us nice fixed income schemes that have little relationship with market rates (even if they should). So no matter how the stock market swings, our EPFs, PPFs and SSYs are fairly stable. So a natural diversification for us is to divide our money between equity and fixed income.
Choosing international securities, in particular stocks is also for the same reason. We hope that the international stocks will do well when our own stocks do not and “bolster returns". However what many investors fail to recognise is that a significant present in the portfolio is required to make a difference. Take an equity-oriented balanced fund for example. While a normal equity mutual fund holds about 95% equity most of the time, the balanced fund holds about 70-75% most of the time. The rest 25-30% is in fixed income. This reduces the volatility by about 20-25% roughly. Still, if there is a huge crash, don’t expect the fixed income to save the balanced fund. It will fall less, but still fall big. To see what I mean watch this (relevant time stamp 12:01)
My point is, if you want to include another asset class or another type of security, it must have a significant exposure in the portfolio to make a difference Adding international funds for 5-10% will not really help much. And remember if there is a 2008 kind of situation, no stock is safe! Also, say that you add that 20% and it suddenly shoots up to 30% will rebalance the portfolio and pay tax as per your slab or hold on to and thereby increasing potential risk in your portfolio? If did not get that, remember international funds are taxed like debt mutual funds.
Also is buying a US based ETF or feeder fund really diversification? Is this not a country specific risk? Sure, sure, buying Indian stocks is also a country specific risk, but at least is our country and a relatively known devil. Remember that a crash followed by an immediate recovery is one thing and a crash followed by a prolonged recovery quite another. If the underlying stocks do not give you returns, the exchange rate benefit will vanish. So if you want to diversify your portfolio with international stocks, you must be ready for (1) significant exposure (2) necessary tax and exit load and (3) true diversification across geography and not just by stocks from one country because “it has been moving up".
With all that said, let us the titular question: Should Resident Indians Invest in Internationals stocks or funds? Im my opinion, but there is no need to. As long as we have nice market de-linked fixed income safe guarding our portfolio, there is no need for any other countries equity. The portfolio will be adquetely risk protected with enough exposure to PPF, EPF or even debt funds and NPS (high on debt).
What are the options for one who wishes to invest in international stocks?
(1) Buy international stocks and etfs via a broking account that offers overseas trading. If I am not wrong, ICICI direct offers this. Note that gains realised on/before 24 months is taxed as per slab and above that at a flat 20%+cess (no indexation).
(2) Buy India based ETF like the Nasdaq 100 or fund of funds or feeder funds that invest in international funds. Here the taxation is similar to an indian non-equity mutual funds. As per slab for gains realised on/before 36 months and 20% with indexation after.
If you know how to pick stocks, the first option is the simplest and cleanest. You can build a truly diversified international stock portfolio diversified across region and businesses (if you know how to). The problem with the ETF (there is only one) and feeder funds are that most of them are country specific. So in the name of diversification, you will adding a country specific risk in your portfolio. Of course, people do this mainly due to recency bias. There are a couple of feeder funds that do offer reasonable diversification across countries.
The Edelweiss Emerging Markets Opportunities Equity Offshore Fund
This invests in the JP Morgan Emerging Markets Opportunity Equity Offshore fund. As of: 31/07/2018, this is the geographical diversification of the portfolio. The Benchmark is: MSCI Emerging Markets Index (Total Return Net)
The Invesco India Feeder- Invesco Global Equity Income Fund
This invests in Invesco Global Equity Income Fund.
|% of Equity|
|Europe – ex Euro||8.41|
|Europe – Emerging||0.00|
|Asia – Developed||3.50|
|Asia – Emerging||3.37|
True diversification almost always lowers risk by lowering returns. And both these funds would not have exactly set investor hearts on fire. Question is, are we chasing returns or diversification. For most, it is the former in the name of the latter.
Disclosure: I hold PPFAS Long Term Value Fund. Currently it holds about 30% of international stocks (70% US stocks). Since this is about 1/3rd of my retirement portfolio, my effective international exposure is only about 10%, which is next to nothing. I like PPFAS because of its lower volatility, but I would like to think that it stems from cash holding and not “international diversification”. I need to dig deeper to say for sure though.