How to choose international funds

If you are convinced about the merits of international investing and are looking to expand your investments beyond domestic markets, the mutual fund route is the simplest way to act on this idea. Opting for mutual funds ensures that you leave the unfamiliar job of choosing overseas stocks to a professional manager. But taking a deep dive into the Value Research listing of international funds, you're likely to find the choices bewildering.

Indian fund houses have sliced and diced international funds in three ways. One, there are funds categorised by the asset class they invest in. In this class, you have global commodities, global real estate, global equities and multi-asset funds, which own several asset classes. Within equities, there are again thematic funds focusing on consumption, brands, agriculture, commodities, mining, gold mining, energy and so on.

Two, there are equity funds classified by regional flavour - emerging markets, ASEAN, Europe, Asia Pacific (ex-Japan) or global opportunities funds - which decide on allocation between regions and select stocks from across the world.

Three, there are country-specific funds playing mainly on Brazil, China, Japan and US equities.

So, which is the best asset class, region and country for the Indian equity investor to bet on? We, at Value Research, don't pretend to know if agriculture stocks will do better than mining stocks in 2019. Or if Brazil will continue to outperform China. If we knew this, we'd be running a global hedge fund! Therefore, what we recommend is that investors take a strategic, and not opportunistic approach, to international diversification.

What does this mean? It means choosing one class of international funds that is likely to offer you the best diversification benefit in the long run and sticking with it through cycles.
On this core, US-focused equity funds emerge as the top choice through the following logic.

Market for global leaders
Of all the global markets, the US offers the widest canvas of choices for stock investors intent on buying globally successful and high-quality companies. Many consumer and tech companies that were born in the US have attained a global scale by spreading their wings across the globe.

For instance, Alphabet, Google's holding company, now has just 47 per cent of its revenue coming from the US market, with Europe/Middle East/Africa contributing 32 per cent, Asia Pacific 14 per cent and Canada/Latin America the rest. With a presence in 80 countries, only 40 per cent of (US) Procter & Gamble's sales come from North America. Europe, Asia, Middle East and Africa make up the rest. While US remains the top market for Amazon Inc, with $120 billion in revenues, Germany, UK and Japan add up to $40 billion and the rest of the world to $17 billion. Amazon is now betting billions to grow the last segment of the pie.

Given that the US is home to most institutional investors, too, leading companies from around the world make a beeline to the New York Stock Exchange or the NASDAQ when they think of listing, because that's where they expect the best valuations. When Chinese e-commerce giant Alibaba decided to go public, the US market was its first choice. Indian companies such as MakeMyTrip and Cognizant are listed in the US, not in India. SEBI is also looking at new regulations that allow successful start-ups in India to seek a direct listing overseas, without a domestic IPO. All this suggests that the US stock market should be the main port of call for Indian investors scouting for the best companies to own.

Low correlation
One of the key attributes you look for in an asset while diversifying your portfolio is that it should have a low correlation with your existing assets. If you are an Indian equity investor, it makes sense to diversify into markets that don't move in step with Indian equities and which contain losses better than Indian equities. On this score too, US markets win hands down.
Running a correlation analysis on the calendar-year returns of the Indian stock market (represented by the MSCI India Index) and emerging markets (MSCI Emerging Market Index) for the last 25 years throws up a high correlation coefficient of 0.88 (the highest is one and the lowest zero). This means that Indian stocks and emerging-market (EM) stocks move in the same direction most of the time. But the correlation between Indian markets and the US market is a more moderate 0.43. This goes to show that though Indian indices do react to US events, the two markets often don't move in tandem.

This is quite evident from looking at the plain returns, too. Whenever the Indian market has tanked big time due to FPI pull-outs or global turmoil, other EMs have melted down right along with it. But the US market has held up better.

Strangely enough, in 2008, when the Sensex crashed by 52 per cent due to the US-centric global credit crisis, the MSCI EM Index fell 54 per cent, but the US bellwether DJIA fell only 34 per cent. In 2011, the Sensex dipped 24 per cent and the EMs fell 20 per cent, but the US market gained 5 per cent that year. The US market survived the dot-com crash better than India and the EMs, too, with a 6 per cent fall in 2000, while the EMs crashed 31 per cent and India dropped 21 per cent!

India's close correlation with other EMs is because many global investors regard all EMs as one asset class and don't make fine distinctions between an India and a Taiwan. When they see global risks rising, they simply pull out from all EMs and redeploy the money back home (usually the US).

This clearly tells us that, to reduce downside risks in bear markets, US funds present a better diversifier than emerging-market funds or funds playing on China, Brazil or the ASEAN. For Indian investors, diversifying into other EMs is often akin to jumping from the frying pan into fire!

Currency factor
A third big reason to invest in US-specific funds is the currency factor. We argued in the accompanying piece that the US dollar offers the ultimate safe haven to global investors and that the rupee (and other EM currencies) has been steadily losing ground against the dollar over the years. When you invest in stocks listed in Europe, other emerging markets or the Asia Pacific, you acquire indirect exposure to the home currencies of these countries. They may not be on as stable a footing as the US dollar. By investing in the US markets, you can take the most direct route to making hay while the dollar shines.

Thematic funds
Right, funds focused on US equities offer good bets to diversify overseas for the above reasons. But why shouldn't you buy funds that play on unique stocks or themes not available in India? For instance, buying a global energy fund can help you own an Exxon Mobil, Schlumberger or Gamesa instead of a boring Reliance or ONGC. Buying a gold-mining fund may give you a thrill compared to owning dicey Indian jewellery makers.

The problem with buying such global thematic funds is that the thrills they offer come with an equal share of chills. Owning a global energy fund would have subjected you to a 20 per cent loss in 2015 and world mining funds fell 36 per cent that year. Commodity funds had a torrid time in 2011 and 2015 when global commodity prices tanked.

While these funds have also had good years, it would call for great timing skills on the part of the investor to know the right times to enter or exit these funds. We do know even renowned global names such as Goldman Sachs and Jim Rogers have failed big time at calling such trends correctly! Thus, these funds are only for super-smart investors - with specialised skills to predict long-term trends in commodities, oil, gold or myriad other assets - or those who are super bullish about such assets.

Unfortunately, most international funds operating in India do not have a long enough track record to help us gauge their return potential over market cycles. However, going by the relative stock-market returns and the above investment logic, allocating a portion of your portfolio (5 or 10 per cent) to US equity should act as a good diversifier to your swadeshi portfolio.

You can do this either through feeder funds offered by domestic AMCs (such as Franklin India Feeder US Opportunities, Kotak US Equity, etc) or through funds that directly buy US-listed stocks (ICICI Prudential US Bluechip, MOST Nasdaq 100 ETF). There's also the option of buying funds that invest part of their portfolio in US stocks (Parag Parikh Long Term Equity invests).

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There is a strong case for having an international fund in one's portfolio. Sadly, Indian investors have not yet woken up to the idea of international investing