Ramesh Pathania/Mint
Ramesh Pathania/Mint

Foreign equity is good, but beware of risks

Use overseas funds to diversify across geographies, but exhaust domestic options first

In the past six months, at least four new international or overseas funds have been launched. And, according to Securities and Exchange Board of India (Sebi), there are at least five draft offer documents for such funds with it. Year-to-date (February end) inflows into all categories of growth funds (equity and balanced funds) has been negative, according to the Association of Mutual Funds of India. But overseas equity funds saw net inflows of around 947 crore. Undoubtedly, investor interest has been captured.

The overseas attraction

Rajesh Iyer, head of investments and family office, Kotak Wealth Management, cited three prominent reasons for the increasing interest in these funds. “Investors have seen good returns in some international funds over the last year and the currency has also favoured that asset. Moreover, since Indian equity hasn’t delivered over the past few years, investors are recognizing the need for diversification across geography," said Iyer.

The US markets have rallied smartly in the past few years while Indian equities have seen a narrow rally. At the same time, starting December 2012-13, the Indian rupee was extremely volatile and corrected 11%. This led to a shift in focus to overseas equity funds. Moreover, domestic non-performance led equity investors to use every upward movement in the market to redeem out of equity funds.

Asset management companies as well as financial advisers have been quick to spot the potential of diversification. Iyer said, “At present, we recommend 5% allocation to US equity-linked funds," adding that investors, too, are more open to international funds now than four or five years ago.

While the currency movement has been a factor, it wasn’t the only reason. Nandkumar Surti, managing director and chief executive officer, JP Morgan Asset Management Co. Ltd, said, “We launched our US equity feeder fund in the thick of rupee depreciation (against US dollar) last year. Since then, the rupee has only appreciated. We are still seeing continued net inflow." The fund in question has given around 8% returns since inception. Hence, the underlying strategy matters too.

This brings us back to the diversification argument. Geographical diversification can reduce the overall portfolio risk and, at the same time, give you access to good quality companies across the globe.

But just like Indian equities can’t deliver high positive returns year after year, international equities, too, have ups and downs. For example, some commodity, gold mining and emerging market funds focusing on Latin America launched 5-6 years ago are now languishing in terms of returns as those asset classes have severely underperformed.

Risk angles

It is very difficult to know today which markets will perform in the next five years. Within overseas funds, there are those that invest in stocks from the US, Europe, China, Asia, even Africa, while some other funds have themes such as agriculture, commodities and gold mining. How do you know which to pick today, and what if you pick the wrong geography or theme? “Investing in global stocks has risks too and one has to focus on good quality and bluechip stocks out here as well," said Iyer.

According to Surti, “Investors shouldn’t just jump into a theme; look for geographical diversification to begin with. The important part is to educate distributors and investors on international markets and the interlink of international events with Indian markets." So, before investing, do the due diligence on the geography, the economic factors and try to have a long-time investment horizon in place.

Renu Pothen, research head, investment advisory, iFAST Financial India Pvt. Ltd, said, “The biggest risk that these funds face is related to currency fluctuations." This means the advantage with US equity-linked funds in the past couple of years, thanks to a depreciating rupee, can turn into a disadvantage if the rupee continues to appreciate. This can even eat into returns if our domestic currency appreciation is faster than what the underlying asset market is able to return. But while you need to be aware of it, the currency impact is more short term. Over a period of time, if you invest in a good fund, which in turn invests in fundamentally strong companies, long-term returns aren’t under threat.

What should you do?

“We would suggest international funds only to those investors who have done the desired allocation into domestic funds and have the appetite to take an exposure into global funds," said Pothen.

First you need to be comfortable with investing in equity as an asset class and that comfort will come from stocks of companies you know and recognize in the domestic market. Only then should you move to the next level of diversification and look at overseas equity.

There are good quality companies all over the world and international funds allow you to invest in them. But don’t buy such funds just for the sake of diversification; consider all risks—geographical and thematic—before taking the plunge.

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