In this article, we are trying to do something really stupid. We are trying to tell people whose home stock market (India) is returning 30% a year to get excited about investing in markets abroad which are giving single-digit returns.
But first, let's go step-by-step and see why everyone is suddenly talking about investing in mutual funds that invest abroad.
What has changed?
A mutual fund wanting to invest abroad could only buy stocks in companies that fulfilled two criteria.
This made it very difficult for funds to scout for good companies; there are very few that pass this requirement, probably just 40 odd stocks.
If the fund manager wanted to invest in good stocks, especially in technology and telecom and other sectors, he could not because these companies would not have listed Indian subsidiaries.
The Union Budget in February 2006 changed this. The above restrictions have been removed. Mutual funds can now invest in whichever stocks they deem worthwhile.
Moreoever, the ceiling on the aggregate investments made by mutual funds in overseas instruments has been increased from $1 billion to $2 billion.
Why it makes sense to invest in various countries
An investor is never recommended to invest heavily in just one particular sector; this makes his investments susceptible to wild swings and his returns will be totally dependent on the performance of that particular sector.
The same point of view can be extended to geographical regions.
There can be certain region-specific events which can heavily impact the stock markets of that region, while others remain insulated to the gyrations. For example, there can be political disturbances, scams (of which India has a history) or even natural calamities that can rock a country or a region.
Take a look at Who is the Best? You Never Know chart. Over here, we have shown how the stock indices of various countries have performed over 11 years. Take a look at the annual returns.
Can you identify a particular trend? No.
Is there any specific country that has consistently outperformed other every year? No.
In fact, there is a fair degree of randomness in relative performance across the globe.
By diversifying one's portfolio, one can benefit from the upside (rising market) and limit one's losses should a particular country experience turbulence and a falling market.
As long as the equity markets are firing on all cylinders, it may not sound a very lucrative proposition. But spreading your equity holdings across regions can definitely add another dimension of diversification to your portfolio.
What you should look for
The fund manager's ability and the quality of fund management offered by the mutual fund are important parameters.
The success will depend upon the ability of the fund manager to identify the right stocks in the right markets to make the most of them.
The quality of fund management too will play a vital role. In the future, as fund houses launch their offshore funds, look for those with global expertise in fund management. Don't just go by their performance in the Indian market.
Having a presence in business of investment management across the globe should ensure they have a fair knowledge of different markets.
What might affect returns?
Even if the fund manager does a good job, exchange rate fluctuations may affect returns.
This is because investments in foreign currency denominated shares are prone to currency risks. If the foreign currency depreciates vis-a-viz the rupee, it will impact your returns negatively.
Let's say Rs 45 = $1
If the value of the rupee falls until Rs 46 = $1, it means the rupee has weakened and the dollar has strengthened.
If the value of the rupee rises and Rs 44 = $1, then the rupee has strengthened and the dollar has weakened.
Now, if the rupee value is Rs 45 = $1, and a person wants to covert $1000 into rupees, it will be Rs 45,000.
If the rupee weakens to Rs 46, he will get more (Rs 46,000) when converting. But if it strengthens to Rs 44, he will get less (Rs 44,000) when converting.
For example, in the four-year period from 2002 to 2005, the Indian rupee has appreciated by more than 6% against the US dollar. There would be a direct negative impact of this appreciation on the returns of an investor (in terms of the Indian currency), who would have made an investment in dollars over this period.
This would require additional skills on part of the fund manager to manage the exchange rate volatility and guard the returns from the potential adverse exchange rate movements.
The players
As of now, Principal Global Opportunities Fund (that only invests in stocks abroad) and Templeton India Equity Income Fund (invests in stocks in India and abroad) are the only two players.