Do not put all your eggs in one basket! No other expression can emphasize more on the importance of diversification in investing.

As you might be aware, investing in different asset classes helps optimize the risk-return trade-off. But for more effective results, diversifying within an asset class is equally crucial.

Under the present market conditions, wherein the Indian equity market appears overheated amidst the COVID-19 pandemic, and India’s GDP growth has contracted to -23.9% (the worst in four decades); investors willing to invest abroad are on the rise reveals the data released by the Association of Mutual Funds in India (AMFI).

As of October 31, 2020, the Assets Under Management (AUM) Fund of Funds (FoF) schemes investing overseas (29 in total) stood at Rs 6,782 crore versus Rs 2,340 crore in October 2019, and the folio since then in this segment has reported a threefold rise to 4.40 lakh.

Consistence outperformance of developed markets —particularly the United States led by the new generation tech or FAANG (Facebook, Apple, Amazon, Netflix and Google) stocks — has attracted many savvy Indian investors towards global equities.

Mutual fund houses, as a result, are expanding their product basked with all sorts of overseas products. Recently, Edelweiss Mutual Fund launched the Edelweiss MSCI India Domestic & World Healthcare 45 Index Fund. Similarly, Axis Mutual Fund launched its maiden Axis Global Equity Alpha Fund of Fund in September. And Motilal Oswal Mutual Fund launched an index fund tracking the S&P 500 Index.

In time to come, many more fund houses may launch schemes with an investment mandate to tap the investment opportunities in the overseas market. Here’s why…

Last week, the capital market regulator, the Securities and Exchange Board of India (SEBI) vide a circular dated November 5, 2020, enhanced the overseas investment limits applicable to mutual funds from US$ 300 million to US$ 600 million per mutual fund without making any change to the industry-level limit of US$ 7 billion. Currently, the Indian mutual fund has collectively exhausted just about 13% of the industry-level limit of US$ 7 billion despite the growing popularity of overseas funds.

SEBI has also increased the ceiling on mutual fund investments in overseas Exchange Traded Funds (ETFs) to US$ 200 million from US$ 50 million earlier but kept the industry limit unchanged in this regard at US$ 1 billion.

For ongoing schemes that invest or are allowed to invest in overseas securities/ overseas ETFs, an enhanced investment headroom of 20% of the average AUM in overseas securities/overseas ETFs of the previous three-calendar-month exposure to overseas securities / overseas ETFs for that month is permitted by regulator subject to the maximum specified limits as discussed above.

With the circular coming into immediate effect, from now on mutual funds investing in the overseas markets will have to mention the amount they intend to invest overseas in their scheme documents. Moreover, the utilization of overseas investment limits is required to be reported monthly within 10 days from the end of each month. If such limits remain unutilized for six months, it will be available for other fund houses to utilise.

Should you invest in International Funds?

If your exposure to domestic equities is well-diversified, have a very high-risk appetite, the investment time horizon is at least 5 years, and do not mind riding on the investment opportunities in certain parts of the globe or across the globe; you may consider allocating around 5-10% of your equity mutual fund portfolio into International Fund/s as a part of your Satellite portfolio from a geographical diversification standpoint.

Some of the prominent advantages of investing in International Funds are:

  • You, the investor, gain from the expertise of professional fund managers and teams who do the difficult task of selecting securities and portfolio monitoring
  • International funds offer a hedge against local events such as political instability, policy changes, and other socio-economic issues.
  • Offer access to some unique propositions-stocks/brands/sector which may not be available in the domestic markets. For instance, FAANG (Facebook, Apple, Amazon, Netflix and Google) stocks
  • Enhances the liquidity aspect of the portfolio
  • Offers geographical diversification
  • Provides a hedge against currency fluctuations (This could prove useful particularly when you are planning for child’s higher education overseas and your home currency is depreciating against the greenback.).

Currently, the weak rupee against the greenback could work in favour of portfolio returns. But much also depends on the track record of the scheme, its investment mandate, and how the global economy fares. It is important you take a top-down and opportunistic approach to assess which part of the world would fare better than the rest while choosing International Fund/s.

Further to zero-in on an International Fund, here are four key things to do:

  1. Study the scheme’s characteristics – Read the Scheme Information Document carefully to understand its investment mandate – i.e. whether it is thematic or invests in specific country/region; the investment objective; how will it allocate its assets; the securities it invests in; the investment strategy; the risk factors; the credentials of the fund manager, and so on.
  2. Check the performance track record – In case of an existing mutual fund scheme, check for how it has performed across time periods and market phases. Check the returns clocked vis-a-vis the risk. Do not evaluate only past returns. While past performance is not indicative of the future, it will help you understand if the scheme has rewarded investors on a risk-adjusted basis.
  3. Know the portfolio characteristics – To get a sense of how the scheme would perform in the future, try to understand its portfolio characteristics —whether it is well-diversified, concentrated, the sectoral exposure, and the individual security weights. Most importantly, an International Fund should stick to the investment mandate. 
  4. Factor in the expense ratio – Given the way International Funds are structured, their expense ratio is higher than domestic funds. Hence, the returns clocked by the International Fund must justify the expense ratio charged. 

Remember, while investing in International Fund carries benefits, certain risks also exist, viz. country and/or region-specific macroeconomic risk, geopolitical risk, regulation risk, and currency risk.

Thus, it is imperative that you thoroughly understand an International Fund —whether it invests directly in foreign securities or takes the FoF route or it is an ETF — before deploying your hard-earned money.

Never make the mistake of including International Funds as a part of your ‘core’ mutual fund holdings.

International funds are taxed as debt funds unless 65% of their assets are held in Indian equities. Short-term Capital Gains (for a holding period of 36 months or less) will be taxed as per your tax slab (as per the marginal rate of taxation), while Long-term Capital Gains (for a holding period of 36 months or more) will be taxed at 20% with indexation benefit.

A combination of factors as discussed above, decide the level of return you can expect from an International Fund.

This article first appeared on PersonalFN here

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