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The Futile Option

The recently-launched China-related ETF product has a range of weaknesses that counteract any positive opportunities that it may have, even that of diversification

Last week, Benchmark Mutual Fund, India’s ETF-specialist fund company, launched an ETF that is linked to the Hang Seng index of the Hong Kong stock exchange. ETFs are ‘Exchange-Traded Funds’, that is, mutual funds that are traded on stock exchanges like stocks. ETFs are always linked to some underlying index or other price, but they are not actively managed by an investment manager. There are a number of ETFs in India which are either linked to one of the indices, or to gold prices.

The Hang Seng ETF, which is called Hang Seng BeES, will be available for trading on the National Stock Exchange (NSE). The interesting thing about this ETF is that it offers the Indian investor a way to diversify geographically in an easy and convenient manner. On the face of it, such diversification should be a good idea as it would offer an investor an asset that may counteract a weakness in one area with better returns in another.

However, that’s the theory. We need to see whether such diversity is actually offered by the Hang Seng. The connection between two investments can be of many different types. The ideal would be if the two assets have a negative or inverse correlation. This means that when one asset does badly, the other does well. Traditionally, gold and stocks and stocks and bonds were supposed to have such correlations. Certainly, the Indian stock markets and the Hong Kong market do not have this kind of correlation.

In fact, the two markets actually have a direct correlation. When one does well, the other does well too. The correlation is very high. Over the last five years, the two indices had a correlation of 0.93 on a scale where perfect correlation is 1 and perfect inverse correlation is -1. The closer the correlation is to -1, the more useful two assets are as diversification for each other. In this sense, buying the Hang Seng ETF is completely useless from the diversification point of view.

However, that’s a theoretical point of view. If two markets gain and lose together, but one generally does better than the other, then for the practical investor seeking to maximise his gains, that’s a useful kind of diversification. In this sense, the Nifty has a better performance over the last five years. However, if one looks a little more closely, then this better performance is basically limited to the pre-2006 period and to the recovery from the crash last year. The rest of the time, there wasn’t much of a difference in performance between both, one way or the other. One can find various patterns in the past graphs, but the bottom-line is that past performances are just a good source of 20:20 hindsight, which again is ultimately useless.

Going forward, diversifying into the Hang Seng is basically a call on whether China will do better than India and whether this difference will be large enough to be useful. My guess is that it won’t be. Hang Seng being available on the NSE will give the punters yet another security to play with. For fund investors who genuinely want to take a call on China and that region, there are X number of funds (normal, not ETF) that are already available that invest in China to varying degrees. These are the Fortis’ China-India fund, Mirae’s China Advantage Fund and JP Morgan’s JF Greater China Equity Offshore Fund.

However, investors just need to be clear that investing in China-related stocks is not a diversification, but an independent call about China.