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  4. How to choose international funds
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  4. How to choose international funds
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  4. How to choose international funds

How to choose international funds

International funds could have significantly improved your portfolio returns in the last 5 years, with their superior performance.  For example, you would have earned a good 5 percentage points more than the Nifty 50’s return of 15.2% (annualized), on an average had you invested in US-based funds in the past 5 years. We have already written on whether you should invest internationally and whether it is essential. So, we’ll move to the choice of funds in this article. 

Most of your questions revolve around which markets to choose and whether you should diversify across markets. Here’s what your choices are and how you can narrow them.

International funds

In 2016, if you invested in the HSBC Brazil fund seeing its massive returns, today, your returns would be 2.2% annualized! Why? Because the Brazilian market, unlike the US, neither saw sustained corporate profit growth nor the kind of money flow that the US did. Similarly, emerging markets, including China, worked well in bursts but did not return in a sustained manner like the US. 

Therefore, you need to be careful on two fronts – the potential of the market you pick, and how much the market differs from our own.

Where is consistent performance?

The data below (all in dollar terms) will tell you that in the past decade, whether it was the developed markets or the developing markets, all have had spurts of outperformance but could not sustain it. Post the financial crisis in 2008, it has become evident that the US market, for multiple reasons, remained a lot more stable than any other market. In fact, while the economic growth of many emerging markets (including India) outpaced the US, the former’s stock markets did not follow this trend. 

Strong corporate profit growth on the back of tax cuts, prolonged low interest rate, multiple economic packages pre and during Covid and strong currency have all been reasons (we are not getting into these details here) for the US showing a far more positive outcome in the stock markets, lower economic growth notwithstanding. Just to give a perspective, an emerging market like India saw the Nifty 50 profits expand by just 6.2% (rupee terms) in the past decade as opposed to the 9.6% growth (dollar terms) in earnings (source: S&P 500 earnings from NYU Stern pages) for the S&P 500 in the US. And this growth in the US comes despite a very large base! Robust corporate profit growth (something that has not been seen in most other countries) has provided a lever for returns in US markets, in addition to other factors.

Coming back to the data above, it is evident that no major market has performed as consistently as the US. If you look at the MSCI World index and the one without the US, you will know which market contributed to returns. You will also see that regions such as Europe pulled down returns (see World ex Europe).

What factors to look at while choosing a market

If the US did outperform in the past decade, can it repeat its performance? We don’t know. But what we can discuss with respect to your portfolio is that, to choose an international fund:

  1.  You need a market that has lower correlation with India, so that it offers diversification and hedging.
  2. You need a market that can generate sustained returns – true for any fund choice you make.

Dejargonizer

Correlation explains how closely related two markets are. For example, if India’s market has a high correlation with another, then both markets will move in very similar fashion – both may go up or down to the same extent or at the same time. Where there is low correlation, India’s market will move differently from the other. Therefore, one may rally/fall when the other does not, or the extent of uptick or corrections will be different. When you plan to diversify, having lower correlated asset classes or segments help de-risk your portfolio.

The data below shows the MSCI India index’s correlation with various markets and regions.  As you can see, India has a far lower correlation with the US than other major markets. Its correlation with China is not very high but including the more robust Hong Kong market and Taiwan, it is marginally higher. The next best option to the US market is to go with a global index. Don’t forget that the World index too has 60% exposure to the US.

In terms of sustained returns, the earlier table of multi-calendar returns across countries in the last decade showed the US in a better light. But even going back in history in terms of returns, the US market’s return (in dollar terms) appears adequate as an asset class to diversify into. The average return of the S&P 500 over different historical periods will tell you that it is good enough a segment to own for the long term, even assuming the next decadal performance cannot repeat itself.

But what happens if emerging markets indeed do better than the US in the next decade? Well, don’t forget that India will be a beneficiary of such outperformance too. As you can see from the earlier correlation table, our markets have a higher correlation with emerging markets, and we are among the key emerging markets. That means your domestic portfolio should deliver anyway! And remember, your international investing is for diversification and not necessarily for outperformance. What you will need is a market that is less volatile and can deliver consistently.

What happens when the US market/economy is hit?Two things : one it is likely to cause a ripple effect across markets given that the US supplies the rest of the stock market liquidity. In such a situation, the flight to safety would likely mean moving to other asset classes like gold. Two, it is worth noting that even in the worst crisis in 2008, triggered by the US, the MSCI US country index fell just 53%,(January 2008 to March 2009),  as opposed to 56-72% fall in other major countries. In other words, the US market’s ability to contain falls better than other markets is demonstrated. It is unlikely that you will need further diversifiers if you invest in the US market.  

So, our summary here, based on returns and correlation of markets, is that:

  • The US market offers good grounds for diversification in an Indian portfolio.
  • Your next bet could be a broader diversification through global funds, which will likely have a chunk of exposure to the US.
  • Markets such as China can be tactical exposures rather than part of your core international exposure.

International funds: what are your choices?

Investing directly in international markets is not within this article’s purview. When it comes to international funds available in India, they can broadly be classified as follows:

  • Funds that invest globally – that is across different markets
  • Funds that invest in specific markets (other than US) or regions
  • Active funds/FoFs that invest in US market or US indices
  • Thematic/sector funds that invest in specific themes

Remember, most of these are feeder funds (or fund of funds). That means the local fund manager is not investing directly in the international stocks. The scheme invests in a foreign fund in that market. So, you should be aware that the local fund manager has little to no control over the performance.

The table above will tell you that the returns of most regional/thematic funds were momentary, tapering off even by the succeeding year. Barring US-based funds, some global funds and a few emerging market funds, the returns scenario suggests that had you picked a mining fund or a World Energy fund or a Brazil or Japanese fund, it would likely have added more volatility to your portfolio. Of course, this includes the local market currency’s movement with respect to the rupee – positive or negative. 

You can sort the columns in the above table to see how many thematic/regional funds, that topped the charts in some calendar years, have moved to oblivion in the next 2-3 years. The learning here is that – if you decide to pick such thematic/regional funds, you should be able to time their entry and exit. That essentially makes them a thematic fund in your portfolio rather than as an international diversifying option for the long term.

Cost matters

Another factor that would need to be considered is the fund expense ratio given that you would likely hold these funds for a longer time frame, if they are part of your long-term portfolio diversification option. The points to note here are:

One, most international funds are FoFs. Your final returns are impacted by the underlying fund’s expense ratio (which you don’t directly pay for) as well as the FoF’s expense ratio. Funds that invest directly in international stocks don’t have to contend with this in-built expense, but as these are active funds, the ratio itself may not be low. You will see this is in funds such as ICICI Pru US Bluechip.

Two, passive options even in the FOF route would score on the expense front. ETF expenses are rarely high.

Therefore, expenses need to be seen in context of the return they are able to deliver. Remember that in an FOF, the underlying or parent fund’s ability to perform matters.

The table below gives the expense ratio of all international funds. Clearly, the expense ratio range is quite high between funds. And remember, the data below is for direct plans, where the average expense ratio is at 1.06%. For the regular plan, the average works out to 1.9%!

But as our analysis thus far suggests, US markets offer the best diversification opportunities. Narrowing it down to only these funds, this is how it looks:

Given that US markets have strong index performance, the passive funds in this list have been more consistently beating the active ones, at a lower cost.

 (Separately, do note that this return is higher than the US returns in dollar terms due to the rupee’s depreciation. In other words, some part of your return came from the rupee’s depreciation against the dollar. This is one of the primary drivers for your total returns from international funds).

Summary

If you decide to hold an international fund, ask these questions:

  • Are you trying to make a tactical investment in a market or theme you know or are you choosing a long-term diversification option for your portfolio? If the answer is the latter, then don’t look beyond US or global funds. 
  • Are you aware of the currency risk in the market in which you are investing? With the US dollar, you may be aware of the rupee depreciation, but do you know about the movement of other currencies against the rupee and its risk?
  • If you are choosing a FoF option, does the parent fund have a sound track record?
  • Is the expense ratio of the fund justified for its risk-return proposition?

If answers to these questions are not easy for you – you can simply go with options in this space that we have – in our Prime Funds. At PrimeInvestor, we do not rate/provide buy/hold/sell calls on international funds as it is not easy to compare different markets and themes with the same set of metrics. We do not also claim to know those markets well. Where we do know a fund will complement your Indian portfolio and has a stable record and low cost, expect us to have them as part of Prime Funds.

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