Should you invest in international stocks?
This post answers the question of whether investors should invest outside their home country.
This post answers the question of whether investors should invest outside their home country.
Global stocks, driven by the US, have witnessed a phenomenal rise in the last ten years. While Indian stocks have also risen considerably in the same period, there has been considerable interest in Indian investors to invest outside India. Household global brands like Apple, Facebook, Google, Netflix, and international leaders like TSMC, Disney, J&J, Tesla, and Samsung are a few examples of stocks available for investing to resident Indians. Indian investors can invest via mutual funds or direct stock/ETF purchases under RBI’s Liberalised Remittance Scheme (LRS).
While LRS is relatively new, feeder funds in India have been there at least since 2007. Given so many options available, this post analyses the benefits, if any, apart from returns of the post-March 2020 bull-run that Indian investors expect to get by investing internationally.
Before talking about international diversification, we need to consider home country bias. This term refers to investors’ propensity to invest only in their resident country’s stock market. Familiarity with local markets, favourable domestic taxation and lack of international investing options are the typical drivers of home country bias.
As per AMFI data, the current (Jul-Sep 2021) AuM of international funds in India is less than 1% of the AuM of domestic funds. Assuming the current proportion of retail investors (< ₹2 lakh) is similar to the Dec 2020 proportion of 20% in the total AuM, retail investors invest less than 5% of their funds in international stocks via mutual funds.
Indian stock market capitalisation is less than 4% of world market capitalisation as per the latest data from companiesmarketcap.com. Indian retail investors can access global companies, market leaders in other countries and sectors, and exposure to multiple currencies by investing outside India. In addition, investors will have complete exposure to the innovation, growth, and improvements happening worldwide by investing outside India.
International investing has challenges in identifying the right countries/companies, tracking social, political and economic newsflow outside India and different taxation policies for international investments. However, there are options in the market today to invest in large global markets sitting here in India, just like buying any other mutual fund.
The primary driver for international investing is diversification. Global diversification has the potential of reducing risks and/or increasing returns. The premise of diversification is that all markets will not fall (or rise) simultaneously. To make diversification work as intended, investors need to follow two rules:
Using data from MSCI, we have used data up to Sep-2021 for multiple global regions:
For outside India, the returns are in USD. At the same time, for India, we have taken index results in both USD and INR to convert freely between USD and INR returns for all the indices.
Plotting index levels from 1999 show that Indian markets have given the highest returns compared to the rest of the world.
However, that return has come along with some spectacular drawdowns that would have tested the patience of Indian investors over the years.
We will examine if it is possible to reduce the risk while getting similar or better returns by asset allocation between Indian and international markets.
The following table shows point-to-point returns for the last 15 years.
As the table above shows:
We take rolling returns/risk (geometric mean divided by the standard deviation for 36 monthly returns) for major regions since 2002 (238 data points).
The chart shows no consistency in the returns on a risk-adjusted basis between international and Indian markets.
Correlation is a statistical measure used to check how two different markets, like Indian and International, move together. Correlation, which is a number from -1 to 1, is used to construct a portfolio:
Low correlations, therefore, are helpful to protect the downside in case one market is falling (or rising) and the other does not. Thus, including international assets with low or negative correlations with India will improve risk-adjusted returns. However, the problem happens when correlations move with time, as the chart below suggests.
This chart shows how diversification benefit disappears when needed the most, i.e. during stressful situations like March 2020 and November 2007.
As the boxes show, correlations spiked post the market fall. If two markets fall together (or rise together), there is no benefit holding them purely from a downside protection perspective.
Using data since 2000, we compare the result of running a 10-year SIP in Indian markets (represented by MSCI India) and consider adding MSCI ACWI World ex India (in INR), representing International stocks with yearly rebalancing. The SIP is increased by 10% yearly as a step-up SIP. In addition, 2% is removed from the portfolio on every rebalancing event to simulate the impact of taxes. Taxation of international mutual funds is handled in this post, which we have simulated using this rule.
There are 142 such 10-year windows (each of 120 months) in this period. Note that the conclusion does not materially change if we consider International stocks are denominated in USD instead of INR.
A single case is shown below.
In this particular sequence of returns, the portfolio with 50:50 allocation to Indian and International stocks has been underwater in 56 out of 120 months. In addition, the portfolio has lost money in ten years with ending NAV below the starting value of 10.
We will plot four metrics:
The charts show three cases: a portfolio of only Indian stocks, only International stocks and a 50:50 mix of the two. It is implied that the intermediate cases will lie in between the two extremes. Note that the USDINR exchange rate has impacted all the results. The impact of the exchange rate is unpredictable and should be kept in mind when constructing an international portfolio.
We see that over time, the SIP in Indian stocks has remained similar in terms of being below the investment amount. On the other hand, international stocks have shown a steady decrease due to the 2000-2021 bull market. Hence combining the two, there has been a gradual trend of reduction of time the portfolio has spent underwater.
We see an interesting trend when the portfolio’s overall return has fallen over time for India while it has risen for International stocks, with the mixed portfolio coming in between. Note that a mixed portfolio will incur taxes due to rebalancing that will significantly impact returns. We get a similar conclusion by looking at the NAV chart.
Risk reduction by diversifying internationally is an unambiguous result. As the chart below shows, as the proportion of Indian stocks reduces in the portfolio, the overall portfolio risk reduces. For example, at 50%, the average risk reduction is around 7% lower than the 100% India portfolio, which has a risk of 24% on average.
We should keep in mind that these are trends that have been observed in historical data. The future may turn out to be entirely different from what these trends show. Therefore, the investor must keep a close eye on portfolio attributes like risk-adjusted return and rolling correlations to ensure that the portfolio does not deviate far from expectations.
Instead of International stocks, we add only US stocks (in INR) to an Indian stock portfolio in the same way as described above and obtain very similar results. When understanding these charts, You should consider the strong recency effect in the post-2020 bull run in US stocks while interpreting these charts.
International investing should be considered by investors who
We are currently having a few options that provide exposure to global markets
We will keep updating the list with suitable funds that provide global exposure. These fund names are not recommendations to invest.
If instead, the investor wants to look at US stocks only, then this article will provide more detail: What is the best way to invest in US stocks?
This question is commonly asked by investors who are yet to start investing internationally. International investing should be attempted only by investors with the discipline and processes to follow goal-based investing. A quick check-list before investing internationally would be
There is no constraint on portfolio size in the above conditions.
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This post titled Should you invest in international stocks? first appeared on 04 Nov 2021 at https://arthgyaan.com