International funds have lately been getting more attention than ever before. The total assets managed by the funds of funds (FOFs) investing overseas have almost doubled year on year in the first eight months of 2020. As of December 2019, their AUM stood at Rs 2,635 crore. Now as of August 2020, it stands at Rs 5,154 crore - growth of about 96 per cent (see the chart below). Even the inflows of these funds have spiked this year. As per the recently released data for September 2020, they recorded an inflow of close to Rs 1,700 crore.
While it is heartening to see investors recognise the importance of international diversification, this rapid growth in inflows is also discomforting as it looks like the current trend is driven by momentum and the relative outperformance of international markets in the near term. Look at the graph below which shows how the net flows of Motilal Oswal Nasdaq 100 ETF have gone up in line with the rise in the Nasdaq index.
So these flows can reverse as the direction of outperformance reverses, leaving investors disappointed. The real reason for investing in international equities should not be the near-term outperformance but geographical diversification. One should not invest in them opportunistically but see them as a strategic allocation in one's long-term growth portfolio. A suitable international allocation should come good on the following three factors.
1. Lower correlation with the Indian markets
By allocating part of the portfolio to international equities, we can diversify better and thus mitigate risk associated with the domestic economy. Although in the highly integrated global financial markets of today, it is almost impossible to find regions which are completely delinked, investing in geographies which are relatively less correlated with the Indian economy can do the job. This will ensure that if anything goes wrong in India, there will be a part of the portfolio which will not get affected by it.
2. Gaining exposure to some of the world's biggest companies
Merely lower correlations do not suffice. They have to make sense as investments on a standalone basis and offer growth potential. So one should ideally look for strong, global companies which tick all the boxes as a sound investment but are not available as an investment option in domestic markets.
The Forbes listing (as on May 13, 2020) of the largest public companies can provide a glimpse of where you are likely to find them. A simple analysis of the same reveals that 37 companies out of the top 100 are domiciled in the United States. This is the highest with a total market value of $11,095 billion. It is followed by China and Japan, with 18 and eight companies, respectively.
If you look at the top 10 US companies by market value, you will see names like Apple, Microsoft, Amazon, Alphabet and Facebook. Though these companies are domiciled in the US, they have a global consumer base. So by investing in them, you actually get a global exposure.
3. Foreign exchange tailwind in the long term
Currency movements are the third factor to consider. You should ideally have a currency tailwind in the long run so that whatever you gain from investing, you don't end up losing through adverse forex movements. So any appreciation in the chosen foreign currency vis-a-vis Indian rupee would mean an additional gain.
The Indian rupee has generally depreciated against most developed-nation currencies over the last 10 years. For instance, the US dollar has appreciated to Rs 73 from Rs 47 over the last decade - an annualised gain of 4.52 per cent. Likewise, the euro has appreciated from Rs 60 to Rs 87, giving an annualised gain of 3.90 per cent. It is very likely that the rupee will continue to depreciate against the US dollar. This is because the dollar has a higher demand than the rupee in spite of the fact that interest rates in India are higher. This higher demand for the dollar stems from the fact that the US is the world's largest economy, the most powerful nation, home to some of the world's greatest companies, and hence the safest investment destination.
Simulating the portfolio
The above discussion and the numbers suggest that broadly developed markets, especially the US markets, tick all the boxes. They have historically been less correlated, have many world-class companies as well as enjoy the currency tailwind. All these are desirable but what about the real outcome an investor would have got by putting these arguments in practice? We tried to find that out by comparing the risk-reward outcomes of a fully India-focused investor with those of someone who invested 20 per cent of his money in the US. See the charts below.
The portfolio with exposure to S&P 500 TRI has returned slightly higher than an all-Sensex portfolio. It returned 14.19 per cent annually as compared to 13.95 of the Sensex portfolio. However, this outperformance is primarily due to the recent returns. More importantly, the volatility in case of the portfolio with S&P 500 TRI was much lower. This shows that an international component can help contain the volatility in your portfolio, without compromising much on returns. Also, a portfolio that had 20 per cent international component fell less when the Sensex corrected by 5 per cent or more within a week.
What options do you have?
The option of investing directly in overseas stocks has always been there. Indian investors are allowed to invest $250,000 (about Rs 1.84 crore) in a year under the Liberalised Remittance Scheme (LRS). That would be more than sufficient for most of us. However, do remember that you should invest directly in stocks only if you can undertake the research required and have the temperament for handling a stocks portfolio. If not, that is where mutual funds come into picture. A professional fund manager can help you navigate this space more fruitfully. Here is a glimpse of the available mutual fund schemes that invest in the United States.