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Land of the Dragon

Benchmark Mutual Fund has come out with the country’s first international exchange traded fund called Hang Seng BeEs. The fund will invest in stocks that make up the Hang Seng Index of Hong Kong Stock Market and will be traded on the National Stock Exchange (NSE).

The question that immediately follows is: Should you as a small investor invest in it or in funds investing in overseas stock markets?

Mutual funds offering investment in overseas markets are not new. Most of such funds available now invest your money through a feeder fund in an existing international fund that invests in global markets, while some of the overseas funds launched here buy and sell stocks directly from foreign markets.

For the motion

The argument for investment in overseas markets is that it helps you to diversify your investment portfolio because equity markets around the globe are not equally correlated. Hence, overall returns on investments spread across geographies are more stable than returns on investments concentrated in one country.

This argument, I believe, holds true for investors in developed markets where the investment returns are generally much lower than those in developing markets. Being growth economies, developing markets yield much superior returns compared with matured economies. You cannot expect a 40 per cent return from equities in the US or the UK. So, portfolio diversification through overseas investment makes more sense for an investor in a developed country than for an investor in, say, India.

Against the motion

While reducing the portfolio concentration risk, overseas investments entail risks of a different kind. These include foreign currency and geo-political risks of the countries where these investments are being made.

If country A is growing faster than country B, the currency of country A will appreciate in foreign exchange value vis-à-vis the currency of country B over time. In other words, the return on investments in country B adjusted for the exchange value will yield a lower return for investors domiciled in country A.

Taxation issues

Besides, there are issues of taxation of investment. Under the current tax laws of India, investments in equities in the domestic markets are exempt from long-term capital gains tax if the investment is held for more than 12 months. In case of equity mutual funds, there is, however, a condition to this tax-exemption. The long-term capital gains tax exemption is available to equity mutual funds that invest at least 65 per cent of its corpus in equities of companies listed on domestic bourses.

Thus, fund-of-funds investing in overseas equities, international ETFs and equity funds investing more than 35 per cent in overseas stocks will not get you the long-term capital gains tax exemption.

Another important factor is that the expense ratio of these funds is quite higher than mutual funds investing in domestic markets — be it passively managed or actively managed funds.

China focus

Let us now consider the merit of investing particularly in China. India and China are the two emerging economies that are widely believed to be the drivers of economic recovery from global recession. It is also estimated that by 2025, China will become the world’s largest economy, surpassing the US, and India will stand at number three in the pecking order.

At present, there are three China-specific funds (see in table 2) and over the last three years they have given a much lower return than the average return of diversified equity funds investing in domestic stock markets.

A study of annual returns of world indices (table 1) also reveals that our own BSE sensex has done better than most other markets, including Hang Seng, except for in 2008.

India is considered to be a highly volatile market because of its large dependence on institutional funds, particularly foreign investors. The retail participation in equity markets in India is far less than in China and other markets.

As a result, when foreign institutional investors pulled out their money from India in 2008 after the collapse of Lehman Brothers, stock prices on domestic bourses plummeted unhindered —there was no support from domestic institutional or retail investors.

In Hong Kong, on the other hand, large retail participation stemmed stock prices from falling to the extent it happened in India.

The strategy of portfolio diversification to ensure stability in return and reduction in risks hinges on the correlation between different assets in the portfolio.

Correlation measures the degree to which the movement in prices of one asset class varies with that of others.

A zero correlation means no association. If the correlation between two asset classes is one, it means prices of both the assets will move in the same direction in perfect tandem.

A negative correlation, on the other hand, signifies when the price of one goes up, the other will go down. A negative correlation is ideal for portfolio diversification.

Now, the correlation between Hang Seng Index and Nifty 50 is found to be 0.64 when calculated on the basis of daily returns over the last three years.

A correlation of 0.64 means when Hang Seng goes up by 64 per cent, Nifty will go up by 100 per cent and when Hang Seng goes down by 64 per cent, Nifty will go down by 100 per cent.

Such a high correlation offers little merit for small investors to diversify their investment portfolio and assume newer risks involving foreign exchange, geo-political and economic risks of China/Hong Kong.

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