How to choose international equity funds

Most equity investors prefer to invest in domestic equity. Investors feel that they understand the domestic stock market including its risks better. While it is true, investors should also understand that, investing only in domestic equity, exposes them to single country risk, even if the country in question is their home country. Investors in developed markets do allocate a portion of their assets to international equity. Of late, Indian investors are also showing interest in international equities.

Benefits of investing in international equity

• Risk diversification: One of the biggest benefits of investing in international equities is risk diversification. International equity is a separate asset class like domestic equity, fixed income, commodities etc. In fact, each equity market is a separate asset class. Investing in international equity will help you diversify single country risk e.g. climate / weather related risks, risks of natural calamities, pandemics, geopolitical risks etc.


• Diversify currency risk: Though currency risk is also part of overall portfolio, it deserves special mention, especially if you have financial goals which require you to spend in foreign currency e.g. overseas education for your children, planning a foreign vacation. International investments will help you diversify currency risk.


• Exposure to investment themes not currently present in India: The stock market in India is dominated by companies in the traditional industry sectors e.g. banking, oil and gas, metals, cement, automobiles, power, traditional IT outsourcing, pharmaceuticals etc. Investments in some international markets can provide you exposure to major technology trends like internet, social media, e-commerce, robotics and artificial intelligence, cloud computing and big data, solar technologies (photo-voltaic cells), semiconductors, electric cars etc.

How to invest in international equities?

We have seen above that it may be prudent to have a portion of your investment portfolio invested in international equities. There are several avenues of investing in international equities. You can invest in international equities by opening an overseas trading account with an Indian broker, who has a tie-up with an overseas broker. There are also Fintech platforms which enable you to invest directly in international stocks. Direct investments in international stocks are subject to FEMA regulations of RBI for resident Indians and NRIs.

However, for investors who do not have knowledge of international markets, industry sectors and stocks, international equity mutual funds or fund of funds (FOFs) which invest in overseas stocks, ETFs or mutual funds are suitable investment options for international equities. Several FOFs investing in international equities have been launched over the past couple of years, in addition to the ones launched earlier. In this article, we will discuss how you should go about choosing international equity funds.

Check for correlation with Indian market

To get benefits of diversification, the asset class you are investing in, should have low correlation with the assets you have in your portfolio. In other words, when some assets in your portfolio underperform, others should outperform. Fortunately, from a diversification perspective, there is low correlation of returns among major international markets. The chart below shows the annual returns (in USD terms) of different MSCI country indexes over the last 10 years. You can see that winners rotated across markets. In order to get maximum benefits of diversification, choose a market that has low correlation of returns with Indian market.

Source: MSCI Indexes, as on 31^st October 2021. All returns are in USD terms. Disclaimer: Past performance may or may not be sustained in the future. Returns in the table are for investor education purposes only to illustrate winners rotating across markets. These figures should not be construed as investment recommendations. You should understand country risks and consult with your financial advisor before investing.

Look for country competitiveness

There are several country competitiveness studies done by various global bodies. The one done by World Economic Forum (WEF) is one of the most comprehensive and widely accepted. Country competitiveness analyses are done on several parameters under the following framework:-

• Enabling environment: Institutions, Infrastructure, Information and Communications Technologies (ICT) adoption, Macro-economic stability


• Markets: Product market, labour market, financial system and market size


• Human Capital: Health and skills


• Innovation Ecosystem: Business dynamism and innovation capabilities

Markets are assessed on each parameter and composite ranks assigned to the markets after rigorous analysis. The last global competitiveness rankings were done by WEF in 2019 (they did not do a comprehensive ranking in 2020 due the extraordinary situation caused by COVID-19), of which we will present some snippets below:-

• Singapore ranks number 1 in Global Competitiveness, while United States ranks 2^nd


• Hong Kong is ranked 3^rd, while Japan is ranked 6^th


• Both Taiwan and Korea (12^th and 13^th respectively) are ranked ahead of China (rank 28^th)


• India was ranked 68^th ahead of Brazil (71^st).

Source: WEF (2019 Global Competitiveness Index Rankings) Disclaimer: Above information is shared only for illustrative purposes and should not be construed as investment recommendations.

You should invest in countries that rank high in competitiveness index. Strong competitiveness indicates good ecosystem for industry and future growth prospects.

Infrastructure and industry ecosystem in the country

• Apart from basic infrastructure like roads, railways, ports, power, telecommunication etc, new age infrastructures like broadband penetration, wireless connectivity, smart cities etc. are important considerations.


• Robust banking and financial system, well functioning capital markets, stable and transparent regulations, policy incentives for foreign investors, low tariffs, stable tax regime etc.


• Liberal Foreign Direct Investment (FDI) regime, level playing field for all players (private sector and public sector), less interference from the Government, strong and well functioning judicial system.


• Large market size, either domestic market or export markets, growing market, free and fair competition, favourable Government policies, anti-monopolistic regulations / policies etc.


• Availability of skilled labour base, easy access to labour, low or no entry barriers for hiring skilled overseas workers or employees.


• Investors may also consider ESG (Environmental, Social and Governance) factors at market and industry level when evaluating markets and industries. Many foreign institutional investors incorporate ESG principles in their investment decisions and you may also decide to do so.

Average retail investors are not likely to have the knowledge to evaluate markets on the above factors. However, fund managers with expertise and experience of international markets have the skill-set and information to make such evaluations.

Sector Dominance

Some countries dominate certain industry sectors due to their unique competitive advantages, position in global supply chain, availability of raw materials and labour, easy access to major trade routes / shipping lanes, research and development capabilities. For example, United States dominates the world in the areas of technology, aviation, defence etc. China dominates in mining and manufacturing e.g. coal, steel, automobiles, electronics etc. Japan is also a leading player in the automobiles and electronics industries after China. China and India are leading players in the pharmaceuticals industry, with China as the largest Active Pharmaceuticals Ingredient (API) manufacturer in the world and India dominating the generic drugs market. Taiwan is known as the semiconductor foundry of the world.

As seen in the past, countries that maintain their sector dominance for long periods of time with Government support and favourable policies. Therefore, it makes financial sense to invest in countries which enjoy sector dominance. If the sector where an overseas market enjoys dominance is present in your current investment portfolio, you will risk diversification benefits in addition to wealth creation potential. However, as mentioned before, international market and sectors knowledge requires specialized expertise, which domestic fund managers may not have. When you are investing in an international equity fund, you should check whether the Asset Management Company (AMC) has access to foreign market local expertise either through the resources of their parent company (if the parent company is incorporated outside India) or through tie-ups with local market asset management companies.

Benefit from currency upside

You can benefit from depreciation of the Indian Rupee (INR) by investing in international equities. Over the past 10 years, the INR has depreciated by nearly 45% versus the US Dollar (USD). Purely for the purpose of illustration, if you invested in US equities, you could have gained nearly 3% every year (on CAGR basis) just from INR depreciation. Several other international currencies e.g. CNY (Chinese Yuan Renminbi), Hong Kong Dollar (HKD), New Taiwan Dollar (NTD) etc also appreciated significantly versus INR over sufficiently long investment horizons. However, we must mention here that currency movement should not be sole reason for international investments because equity risks can be far more than currency risks.

Conclusion

Interest in international equity is growing in India. As per AMFI data, assets under management in fund of funds investing overseas stood at Rs 24,000 crores (as on 31^st October 2021), nearly a three and half fold jump year over year. In this blog post, we discussed the benefits of international investing. We also discussed the different factors that you need to consider when selecting international equity funds. You may not have access to all the information beforehand, but if you understand the different factors that we need to consider, then you will be able to make better sense of the information contained in the Scheme Information Document (SID) and make informed investment decision. As always, consult with your financial advisor, if you need any help in making investment decisions.