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Monday, Feb 23, 2004

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Benefits and costs of investing abroad

B. Venkatesh

THAT the Reserve Bank of India (RBI) has permitted investors in India to buy foreign assets to a maximum $25,000 is indeed commendable. Such a move enables investors to diversify globally though in a small way. Domestic mutual funds have already begun approaching potential clients to manage funds. This article looks at the benefits and the costs of optimally investing abroad.

Fund structure: Should funds invest directly in global equity or should they invest in mutual funds that take exposures in global equity? It is highly likely that fund-houses will target US market to start their investment venture abroad. Investing directly in the US market requires stock selection skills. After all, it does matter whether the fund invests in IBM, Microsoft or AMD.

The point is that domestic fund-houses do not have proven expertise in the US markets. They will have to rely on research reports initiated by US firms. And even if they were to use such reports, monitoring the portfolio will be difficult. Foreign funds that have a base in India, such as Franklin Templeton India, no doubt have an advantage. They can use the research reports of their US counterparts and take direct exposure in US stocks. But investing in US-based mutual funds seems a more realistic and cost-efficient strategy.

Active Vs passive management: If investing in US mutual fund is an optimal choice, the next question is whether to buy active funds or passive funds. Empirical evidence suggests that active funds increase return per unit of risk. Suppose a portfolio manager of a domestic fund generates returns of Rs 2 per unit of risk. If the domestic fund buys units in an active US fund, the portfolio may perhaps generate on an average Rs 2.65 per unit of risk.

Investing in passive funds has a different effect. This essentially involves the portfolio manger in India investing in US-based index funds. In such cases, portfolio risk is likely to come down. That is, investing in a US index fund will lead to, say, returns of Rs 2 per 0.90 unit of risk.

Asset allocation process: Should an existing domestic fund take exposure in US equity or should a fresh fund be floated for the purpose? There is clear advantage in the former and that is asset allocation. Take a diversified growth fund in India. The portfolio manager can enhance portfolio returns through tactical asset allocation. This essentially involves increasing or decreasing exposure to US-based mutual funds based on the portfolio manager's view of the US markets. If a separate fund were to be launched for investing in global equity, the responsibility of dynamically allocating assets rests on the investors. And not all investors are competent at such asset allocation.

Asset allocation is an important process in constructing a portfolio. The Nobel-prize winning economist, Mr William Sharpe, for instance, empirically proved that more than 90 per cent of portfolio returns could be attributed to asset allocation. This essentially means that it is very important to decide the proportion of assets to be allocated to each market — something that a professional money manager can be expected to do well.

Trade-off: The portfolio diversification benefit due to investing abroad comes at a cost. Unit-holders will have to suffer double fee structure. Investors will have to pay a management fee to the portfolio manager in India. Besides, the domestic fund will have to incur a management fee when it invests in a US-based fund.

Finally, Indian stock markets are largely independent of the US market under normal conditions. That is, how equity values move on the NYSE and the NASDAQ do not influence the way equity values move on the BSE and the NSE. A recent study suggested these markets do not co-move, except that the opening on the BSE and the NSE is affected by how equity values closed the previous day in the US markets. There is, hence, a compelling reason for investors in India to diversify.

But the important factor is that such diversification applies to normal markets, not when there is a market crash or panic selling. During the Asian financial crisis in 1997, for instance, equity values in most markets tanked. While not suggesting that diversification fails during such period, investors will have to note that risk increases during abnormal market conditions.

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