And recently, again, the markets felt the jitters as tensions between Russia and Ukraine escalated into a war. This changed investor sentiment globally. The MSCI All Country World Index (ACWI) saw a decline (peak to trough) of -10.6% from its January 2022 peak.
Indian equities also took the brunt due to a further rise in commodity prices, especially oil and industrial metals (commodity prices had already risen before the war due to strong demand recovery and supply-side issues) , leading to increased risk aversion and concerns. -High earnings expectations rating.
It is a hard truth of investing that the biggest downside for an investor is the risk itself. While high inflation, market crashes, and pandemics can all cause short-term disruption, permanent damage occurs when we make poor investment decisions driven by greed or fear.
How can investors limit downside risk? One can reduce downside risk by diversifying into defensive assets such as cash and fixed income. However, the current low or negative real rates – that is, after adjusting for inflation – do not make it attractive enough for investors to park a substantial portion of their money.
History shows that investing in global equities as well as investing in the local market has helped investors generate wealth at moderate risk as the drawdown is lower for a globally diversified portfolio versus a portfolio investing only in India equities.
To give a perspective, during the pandemic, the MSCI ACWI saw a fall of 29% against the S&P BSE 500 index, which was down 38%. Going back in time, during the 2008 global financial crisis (GFC), global equities declined by 46%, while Indian equities declined 66%.
Needless to say, equities as a growth asset came back strongly from both the major declines.
There are a number of factors that justify the low downside by investing in global equities.
1) From a fundamental diversification standpoint, we strongly believe that global investment confers exposure to various international economic and fundamental growth drivers that respond differently to contingencies.
2) It also provides hedge against rupee depreciation – adding to the overall asset return. The numbers speak for themselves. US equities have delivered 19.3% yearly in INR terms over the past decade, outperforming Indian equities by a huge margin, which delivered 14.9%. This has increased the interest of retail investors to participate in global equities, especially US equities.
Traditionally Indian investors can diversify into global equities through funds domiciled in India. Pre-Covid (February 2020), the assets of the category of Global Funds were lagging behind at Rs 4,200 crore and by March 2022, these assets increased to Rs 38,000 crore, of which around Rs 22,000 crore is invested in US equity funds. Retail investors really took note of the hype surrounding US equities, especially FAANGM shares.
Strong inflows into global funds prompted the regulator to step in and around the end of January, the regulator advised mutual fund companies to stop further investments in foreign stocks to avoid breaching the foreign investment limits set by the RBI.
The regulation states that foreign investments of up to $1 billion can be made per mutual fund, with an overall industry limit of $7 billion. The regulator was expected to drastically increase the foreign investment limit. However, as this did not materialise, fund companies had to stop accepting fresh inflows into international funds from February 2, limiting investments through existing SIPs or STPs only.
The situation was further complicated as some fund companies decided to stop the inflow of international funds from existing SIPs and STPs. As a result, investors flocked to some of the international ETFs listed on NSE and BSE. Then, given that new units cannot be created due to existing restrictions, investors can only buy ETF units that are available on exchanges.
This led to an increase in demand for international ETFs, with limited supply and liquidity. The result is that the ETF’s recent performance has seen deviations from the index it is tracking. For example, from February 1 to April 27, 2022, the Nippon India Hang Seng ETF gave -0.85% compared to -14.3% given by the Hang Seng Index it is tracking. The Motilal Oswal Nasdaq 100 ETF gave -1.71%, compared to -10.51% given by the underlying Nasdaq 100 Index.
This clearly indicates that the ETFs are not accurately reflecting the decline in the underlying index and this divergence can increase largely due to the demand and supply for these ETFs. New investors will pay a higher price than the price of the underlying index. Given that the performance gap is wide, once restrictions are lifted, this could result in a negative impact on investors.
Why was the investment limit not increased? No one will have the answer to this question – leaving it open for market participants to speculate.
Does not investing in global markets make a difference to an investor? We believe, of course, it does make a difference. As mentioned earlier, it makes sense to diversify a portfolio fundamentally in markets that offer good valuation opportunities.
As a valuation driven investor, we aim to identify opportunities in global markets where valuations are less than their appropriate multiplier. This helps in minimizing the chances of losses and maximizing the chances of returns if the market is trading below the appropriate level and vice versa.
Are there any attractive opportunities in the global markets? Emerging markets (EMs) have weakened the ACWI index, which is offset by heavy losses in China and more recently in Russia. On a year-on-year basis, MSCI EM Index gave -21.5% versus MSCI ACWI Index which is down 3.1%. The MSCI China Index gave -41.6% for the same period, as the Chinese tech giant saw a major correction (-52%) triggered by regulatory crackdown.
Improvements in EM have led to a wide valuation gap between India and EM, making EM and China, in particular, relatively more attractive from a valuation standpoint. For US equities, we see two offsetting developments. On the one hand, the force of reform is driving fundamental reforms and consistent growth in corporate profits in most sectors.
On the other hand, we must acknowledge that much of the recent rally was sentimental optimism, with valuations rising, creating potential weaknesses amid higher interest rates. Overall, at current prices, US stocks still look expensive overall, according to our analysis, both in absolute terms and relative to international markets. However, this sentiment has softened after the recent fall in the market. Apart from this, Europe and the UK also offer attractive investment opportunities.
Existing regulatory restrictions deprive investors of the opportunity to participate in global markets where equity market valuations are attractive. Given the lack of an alternative investment avenue for retail investors to participate in global equities through INR denominated products, they need to stay afloat till the investment limit is raised.
Data Source: Morningstar Direct
(The writer is Associate Director, Capital Markets & Asset Allocation, Morningstar Investment Advisor India)