The Mutual Fund Show: Why Investors Need Global Equity Exposure

GAURAV RASTOGI: So, let’s break it down into two or three different parts. Let’s say the first part is, who should invest in international funds? Ideally, everyone should have an international allocation in their portfolio. Allocations are percentages of your portfolio so it doesn’t matter how big your corpus is. Someone who’s doing a Rs 5,000 SIP versus someone who’s doing a Rs 50,000 SIP versus someone who’s doing a Rs 5 lakh SIP, as a percentage of your portfolio, if the minimum requirements are allowed by a fund, then you should think international investing for multiple reasons. I’ll just give you a quick rundown on why one should think about this. The biggest of course, is diversification. We usually look at S&P 500 and what we find is, over the past 20 years, the 3-year rolling correlation which basically means S&P 500 and Nifty 50, do they move together or how much do they move together? So, assets which move together don’t add diversification to your portfolio. Assets that don’t tend to move together, add diversification to your portfolio. So, what we find is, that the three-year average correlation in the last 20 years is about 30-34%, which is kind of what is the correlation you will find between G-Secs and Nifty 50 as well. So, it does provide you a diversification.

Second is, if you think about the MSCI global index I mean sometimes we have said this before too that if an alien lands on earth, and has no idea about what India is, what U.S. is and wants to own an index portfolio, by default they’ll end up owning 66% of the U.S. market because that’s the weight on the MSCI World Index. By the lottery of birth, we are born Indians it does not mean that we have to have disproportionate investments in India. There’s a term for this, it’s called home bias. The tendency for investors to disproportionately invest more in their home country assets or assets that they know best. So, these are some of the reasons. The U.S. companies generate about 29-45% of their incomes from abroad. So, a diversified portfolio gives you global exposure, helps you avoid this home bias too. So, pretty much, everyone should have an international exposure.

Coming to the second question, who is actually investing and how much they are investing. So, that’s very interesting for us to look at the data too. On average, what we find is that across all the portfolios roughly about 5.5% of the portfolio is allocated to international exposure and majority is through mutual funds. Is this the right amount? That’s very hard to say, our math says that the allocation should be somewhere in the 10-20% range. In the past we have recommended roughly about a 13% allocation to international assets that is going back to 2017. What are people investing in, is again very interesting. Both the questions and also your observation that there has been a flux of international funds recently have to be looked through the lens of what have international funds done in the recent past. Whether you look at Nasdaq whether you look at S&P 500, the returns have been really good. Fund houses are seeing that, investors are also seeing that. So, we do see that Nasdaq 100 fund is very popular as an asset from Motilal, it is one of the oldest Nasdaq 100 funds out there. That’s very popular that users invest in. When we first recommended international funds in our portfolio that’s back in 2017, I think our choices were limited to four or five in order which also a couple of them were sectoral funds. There was the DSP Mining Fund which is a pretty old fund, there is a DSP Agriculture Fund which is also a very old fund. If you look at broad market funds, I think Franklin used to offer one and Franklin still offers one I should say. So, Franklin offers one and ICICI offers one. Our recommendation was the ICICI Prudential U.S. Bluechip Equity Fund.

GAURAV RASTOGI: Our view, and this is a view that we have kind of mentioned again and again in the Indian context too. Sector timing is very hard. It’s very hard to time Indian IT, Indian pharma, and most people lag. The sector moves, then a flood of money comes in and then the sector derates and then the money goes out. So, even though the sector has a certain performance, most investors are not able to capture it which is what is popularly known as the behavioural gap. So, the same thing applies in the international context also. We would suggest that it’s good to know that you can invest into mining or you can invest into specific sectors but it’s very hard to time it as it is hard to time Indian sectors. So, unless you have some expertise or some kind of advantage or edge in the way that you analyse the markets—the macros and the micros, we would suggest, stay away from it. When it comes to regional exposure, should you go for a track fund or an Asia fund or a European fund, they are not bad. They’re also well diversified, they’re targeting a very large GDP area so it’s not like you’re investing in a small country. You are investing in a country with a substantially large GDP. So, they’re fine to have. The only edge I think that a broad U.S. market has, and some of it that I mentioned earlier was, if you look at S&P 500, then I think 2020 data says that 30% of their revenues come from international sales.

If you look at Nasdaq 100, about 45% of their revenues come from international sales. So, although what you’re buying is a U.S. index, you’re actually getting a truly global exposure which will be missing if you go for some of the other regional funds. European companies do not have that much international earnings, Australia is an exception because they are a big exporter of commodities. Chinese companies do not have that much international earnings. So, some of the other regions actually give you pure regional exposure and if that is what you want, you should definitely go for that. But you have to understand that, that is what you’re getting. With U.S., what you get is, you get the best-in-class market but you also get a global exposure to where are these companies making the revenues and profits from.

GAURAV RASTOGI: Not really. So, you just have to be clear—whether it’s like an equity fund of fund. I might be wrong with the actual numbers but if the fund of fund is set up as an equity vehicle, then the taxation is exactly the same as equity or else the taxation is like debt. But you don’t have to worry about LRS (liberalised remittance scheme), you don’t have to worry about how your money goes abroad, you don’t have to worry about foreign taxes and all of that. Everything is taken care of for you, you only have to worry about Indian taxes so it will be either taxed as an equity fund or taxed as a debt fund. Both are fairly simplistic in India, but that’s all you have to worry about. Taxation wise, the mutual fund structure actually scores heavily.

You don’t have to worry about sending money abroad so the entire LRS piece is side tracked. You don’t have to worry about what conversion rate that you’re going to get, you’re not going to worry about what fees your bank is going to charge, you don’t have to worry about how the remittance back into the country happens...

GAURAV RASTOGI: It’s simple math. Your international fund return in INR is your international fund return in the international local currency and the currency exchange rate. So, when you invest international, you are hedging INR by buying whatever that foreign currency is. Now, that hedge can work in your favour or that hedge can work against you. If INR depreciates against the U.S. dollar, that hedge is working in your favour. The international fund returns in INR is higher than the fund returns in U.S. dollar because you’re gaining from the INR depreciation. But if INR appreciates against that currency, then you’re losing out but that’s a part and parcel of international investing and it’s actually a very good point. Very few people think about it deeply but when you are buying an international asset and it could be any international asset, the currency exchange rate movement will affect your INR returns. In a way you’re diversifying away from INR as well. So, when you think about it, you’re getting currency diversification and you’re getting stock market diversification too but there’s no guarantee that will work in your favour.

GAURAV RASTOGI: In terms of flows, I think Motilal Nasdaq and Motilal S&P—both index funds that they have seen fairly good traction and I think they were the first international index funds in some sense. International funds that track an index, they do see a lot of traction on our platform. It is hard, I mean I agree with you, it is hard, there are 38 funds, it’s really hard to figure out which the right fund is in which you should be investing in and it becoming harder because there are a lot of new fund offerings that are happening too. It’s a space that is growing, I think there is a much larger realisation and an investor population that international diversification matters in. AMCs are trying to fill that demand, they’re trying to create products which they think but effectively what happens is when you’re sitting out of India, there’s only that much differentiation that you can create. So, a lot of the funds will end up having very similar portfolios especially if they’re investing in the U.S. market, it will be large-cap. If they invest in other regions, then yes, there is this differentiation. It can be a Japan fund or it can be a China Fund and then there they are actually taking risks but that risk is limited.

Like I said before also, there are no red flags in terms of AUM—whether small or large compared to the Indian market, the flows we talk about at the end of the day, like I said earlier, the international exposure in sum total is just 5.5% of the average portfolio, that’s not much. We’re not talking about that numbers are going to move any large market. In terms of AUM, it doesn’t matter much. The only thing that you have to be worried about is that the AUM is a really small, there is a lot of costs that is split over that small AUM. So usually, either the expense ratios will not fall because traditionally what we have seen is as the fund size grows some of economies of scale savings that a fund house has for a larger AUM, they will pass it on as a lower expense ratio. That will most likely not happen in a small fund because the small corpus that they have, has to bear the entire cost of operating that fund. In international funds, there are costs associated with it, there are fixed costs, there are trading costs associated with it too which the AMC will pass on. So that’s one thing you have to take in mind.

I would say that if the AUM is really low then just ask yourself, is there a really bullish reason to buy this fund and is this the only fund that gives you that particular exposure? It might still make sense if you have a very strong view but otherwise, stick with a diversified fund that has a decent or a large AUM. Most of the large U.S. diversified funds will satisfy that criteria. The only other thing that I’ll add here is that if you’re investing in an international fund of funds, then be very careful that you look at the pass-through expense ratio and not just the expense ratio of the fund of fund. There is not a single established practice on how this is done. Some AMCs, when they disclose an expense ratio, they say this is the expense ratio of the underlying fund, this is our expense ratio, a plus b, this is the total expense ratio that you have paid. I think under SEBI disclosure, you can only disclose the expense ratio of the fund of fund and that’s also fine. In some cases, you have to actually dig in and find out that there is another expense ratio of the fund that this fund of fund is investing in and you have to add that to your costs because it’s also coming out of your pocket. So that’s just one thing that we should also be aware of because sometimes what happens is, a lot of these funds or funds, their expense ratio looks artificially low.

GAURAV RASTOGI: At the top of my head, if it’s a fund of fund just make sure that you’re looking at the look-through expense ratio and not just the expense ratio of the fund of fund.

GAURAV RASTOGI: I’ll tell you my personal views here. What I like about this fund is, it’s actually a very unique offering in a couple of ways. In the U.S., there’s a money manager called ARK and they do this highly concentrated portfolio. At one point, they were holding 20% and 20% of the fund was invested in Tesla. So, very concentrated bets. I think this is one of the first funds in India that is trying to follow the same philosophy where they’re saying that they’re going to have 10 positions with 10% each. It’s definitely not a diversified fund. The fund carries concentration risk, the fund is not for everyone. So, you have to be very clear and know what you’re getting into. So, who is this fund for? This fund is essentially a big bet on big tech. If you really believe that software will lead the world, if you really believe that the more that these large tech companies have built can continue for another decade or two and lastly companies usually have a multi-decade moat. So, it’s not an illogical viewpoint to have but you have to have these very strong viewpoints to then get into investing with this fund because this fund will be volatile. You have only 10 names, you have massive idiosyncratic risk. A single Apple miss can mean a lot to you in a fund like this and on the other hand if Apple beats, then that could also mean something very different on the upside. So that’s the nature of this fund, it’s a unique offering it’s not for everyone. I would say that the other risk here is that, how do you rotate these names? You have 10 names, how do you rotate these? So, you’re taking a little bit of disruption risk because if any of these businesses get disrupted then what happens? The other plus side of this fund is that they’re rebalancing it back to 10% on a periodic basis. This is actually fantastic. It’s an equal-weight fund which gets rebalanced. So, what happens is if Apple underperforms, you’re buying Apple, if Apple outperforms then you’re selling Apple. A rebalancing effectively is a buy-low, sell-high strategy. So, that’s one way that they are trying to capture some of that reversion to meet alpha. So, overall, I think it’s an interesting option and it’s a very unique option. As I mentioned, international funds are hugely popular in the U.S. and they take super concentrated positions. I think this is the first time someone is trying out something like this in the Indian markets. So, I am very excited to see how investors react to it but like I said it’s not for everyone, you have to be absolutely clear that this is a very big bet on big tech. I don’t think anyone else offers such a concentrated portfolio. So, this is definitely one point where you can kind of say you can get Nasdaq but you will not get the same kind of beta or alpha in this fund that you will get in Nasdaq. So that’s the difference. It’s almost like a leveraged Nasdaq position in some sense if you can think about it like that.