International funds – what are your options now?

Funds investing internationally were the flavour of the season all of last year. That changed in February this year, when funds hit the ceiling set by the Reserve Bank on how much they could invest in overseas securities. When we first explained the scenario, expectations were that this cap would be increased in due course and international funds could open up again.

Well, it’s not panned out quite like that! So, here’s taking stock of the situation, the options you have, and answers to other questions that we have received from you.

Background of the issue

First, a quick refresh of the different aspects of the situation with international funds. At the heart of the situation is the Reserve Bank’s limits on how much the mutual fund industry as a whole can invest overseas, coupled with SEBI’s caps on individual AMCs. There are 3 points to note.

• There are two different caps. The first is on investing in international securities which covers stocks, ADRs/GDRs, debt instruments, derivatives, MF units and REITs. This industry-wide limit is $7 billion. The second is a separate cap of $1 billion for funds investing in ETFs.
• For each of these limits, SEBI sets a cap per AMC. For international securities, the per-AMC limit is $1 billion. The per-AMC ETF limit is $300 million. That means some AMCs can be closer to their own cap compared with others.

Early this year, it was the $7 billion cap that was close to being breached thanks to hefty inflows in these funds as well as soaring markets. Funds that were investing internationally, therefore, had to stop accepting fresh inflows through any means, whether SIP or STP or lumpsum (note here that this did not include funds that invested in a mix of domestic stocks and international stocks). The $1 billion ETF limit was not in danger and funds that invested in international ETFs continued accepting fresh money.

Some inflows permitted

However, by the time June rolled around, the global market correction and redemptions that funds saw allowed some headroom for funds. Accordingly, SEBI allowed international funds to accept inflows and restart investing overseas – provided they did not breach their limits. Consequently, AMCs were not uniform in their response to this relaxation. 

For example, HDFC AMC opened up all forms of inflows in its HDFC Developed World Indexes Fund of Funds. ICICI Pru also restarted fresh investments in its five international funds and so did PGIM AMC. 

Franklin Templeton, on the other hand, accepted neither new lumpsums nor new SIP/STP registrations in its three international funds. It simply restarted the SIPs that were already registered in its funds and which were on pause mode owing to the breach of limits. Mirae Asset set lumpsum limits in its fund-of-fund international schemes and continued to keep systematic investments suspended. Motilal Oswal made no relaxation at all in its key Nasdaq 100, S&P 500 and MSCI EAFE Top 100 funds.

Why did funds come up with such mixed responses? Each AMC’s call on accepting inflows in its funds is dependent on the room it has within its own limit and the overall market movement. It will not be possible to gauge how quickly this headroom narrows or what action the AMC may take. So, the SIPs you start may run for now but again stopped forcibly. Or, you may be unable to make lumpsum investments to build your exposure if it was low or if you want to capitalise on market dips.

Consider Nippon AMC, for instance. It resumed accepting inflows in its five international funds from June 22, saw rapid inflows which pushed the AMC to close the funds off a week later as they were nearing their cap, and opened it back up in early August.

In our view, this will-it-won’t-it over a fund’s accepting inflows is not worth dealing with when trying to maintain a long-term investment portfolio with set allocations to international funds. Without an overall industry-wide revision of the caps, uncertainty will continue to persist.

What should you do now?

Given this scenario, this is how you need to view your investments in international funds: 

• Investments you already have in international funds 
• Fresh investments you may want to make

A further separate split to make is funds that invest in international securities falling under the $7 billion cap and those investing in international ETFs falling under the $1 billion cap.

Existing investments

For investments you have already made, there is no necessity to take action on the same and you can continue to remain invested in them. However, a few caveats here.

• As we explained last month, given the global and domestic scenario, it is best to trim your allocation to global funds to 10-15% of your portfolio if your exposure exceeds this. This is also the general allocation we suggest for international exposure in a portfolio. This includes both normal international funds and funds-of-funds investing in international ETFs.
• In that same report, our suggestion was also that you stick to US-centric funds. If you have investments in other global funds, you can take a decision to hold on to them or gradually reduce exposure. Please note that we do not have a view on every international fund there is; our analysis tells us that US markets are the best market for diversifying internationally and we prefer the passive route to investing in this market. This report on how to choose international funds explains more. 
• For non-US funds, another point to be aware of is that any curbs can restrict your ability to invest across market phases. As there are ETFs and other passive funds tracking US indices, the risk is mitigated when investing in US markets. 
• If the fund you hold comes under the $7 billion restriction but has now opened up, any resumption of the curbs may impact its performance or your ability to continue SIP.

Many of you ask us whether you can hold some of the funds you already hold. Our response is: we do not have a view on the non-US funds. Within US funds, we prefer passive funds. We mention later in this article about our preference. We go with those where we can expect low tracking error. Please note that it is hard to judge real performance, since benchmark data in rupee terms is often unavailable. 

In our recommended Prime Funds, we earlier had two international (passive) funds – Motilal Oswal S&P 500 Index fund and Motilal Oswal Nasdaq 100 Fund of Fund prior to the curbs. These funds directly invest in the underlying index stocks to mirror the index. Both remain closed for fresh investments. 

Our recommendation is that you continue to hold all investments made in these funds. Do not redeem. Use the other passive options (explained below) to average your costs, especially if you have invested through the bull run of the past few years.

New investments

Given the uncertainty over acceptance of fresh inflows in funds under the $7 billion cap, it’s best to avoid using the current window to make fresh ongoing investments. If you want to invest in the funds – say to average down costs – lumpsum investments are preferable to SIPs.

That leaves the following:

• Domestically-created ETFs, listed on the NSE or BSE that track global indices. 
• Fund-of-funds investing in international ETFs which have no restrictions and no concerns over hitting their RBI cap of $1 billion as of now. 

The list of these funds is below. Essentially, barring the DSP Global fund, the remaining are only passive options.

In all these options, note that it is hard to arrive at the real tracking error of the funds or ETFs as rupee-adjusted returns for the underlying indices are not available.

#1 The ETF route 

Now, consider the ETFs first. There are two ways you buy units of an ETF.

• One, through fresh creation of units that happens at the time of NFO (unit creation happens later too for very large value investments by institutions or to ensure demand supply equilibrium).
• Two, through units traded in the market, just like stocks. This is where you mostly buy, other than in the NFO period. 

As ETF units are traded only in the secondary market and there are no fresh inflows, investing in them is not under any restriction. That means, you can continue to buy and sell ETF units in the stock exchanges, subject to their market liquidity. 

But there are risks here as well:

• ETF trading has no restrictions but the fresh inflows of an ETF, if any, are invested in overseas stocks and therefore falls under the $7 billion RBI curb. If restrictions resume, the ETF will not be able to collect fresh money and create more units to balance demand and supply on the exchanges.
• The above also means that the risk of tracking error is much higher. The ETF may not be able to maintain stock weights correctly at times to reflect the benchmark, if they cannot deploy fresh money when it is needed. This may cause the NAV to deviate more from the benchmark. 
• To know whether this disequilibrium exists between demand supply, it is important to study the deviation of the market price (price at which you buy or sell on the exchange) from the NAV (the underlying value of the ETF). A quick look at this market price-NAV differential from the time the curbs were set in February shows that they all saw a spike in deviations in months such as April and May. For ETFs such as the Motilal Nasdaq 100 ETF and the Mirae Asset S&P 500 Top 50, this has narrowed to a large extent now though it remains volatile. Volumes have held fairly stable in the Nasdaq 100 ETF, as well, through the months. However, for ETFs such as the Motilal Oswal Q50 or Nippon India Hang Seng, the differentials remain very high going as much as 10-11% at times. Volumes are also low and erratic.

#2 The FoF route

The funds (basically fund-of-funds) investing in international ETFs don’t share this risk, as they can currently continue to invest in their mandated ETFs. Some funds such as the Nasdaq 100 funds from Kotak and Aditya Birla, in fact, list out several ETFs that they can invest in to ensure that they stay with the better ones. These fund of funds, therefore, are preferable to the ETFs. Unfortunately, given that most of these funds track the Nasdaq 100, you have limited choice outside of the Nasdaq 100.

Our current recommendation is Kotak Nasdaq 100 FoF,  part of Prime Funds. If you have any SIPs running in our earlier recommendation of Motilal Oswal Nasdaq 100 or Motilal Oswal S&P 500, shift the SIP amount here and continue investing. 

To summarise

• Continue holding investments already made, provided these are funds that offer good diversification and are worth holding in your portfolio. This article on how to choose international funds will help.
• For fresh investments, if you’re looking at funds that could come under restrictions again, aim at lumpsum investments rather than SIPs given the uncertainty involved over how long they may accept fresh inflows. You can also choose to avoid these funds altogether.
• For fresh investments, opt for fund of funds investing in ETFs first. Only if you need to, go for the ETFs and choose those tracking the Nasdaq 100 or the S&P 500 Top 50.