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Suresh Krishnamurthy

The RBI's proposal to allow mutual funds to invest in index funds is welcome. It should also go the whole hog to allow them to invest in any stock of their choice. Active mutual fund investing in overseas stocks needs to be given its due.

IN the first few months since its launch, Principal's Global Opportunities Fund, which invests in overseas stocks, has proved a point — the benefits of diversification. Now, we can expect more mutual funds to join the bandwagon and launch such funds. The RBI's proposal to allow Indian mutual funds to invest in overseas index funds is timely in this respect.

This, however, may not be enough. The RBI and SEBI should go the whole hog and offer mutual funds complete freedom to invest in overseas stocks of their choice. Such unrestricted freedom may be essential to make global investing more attractive for Indian investors.

Principal's performance: The universe of stocks for Global Opportunities Fund is fairly restricted. It can invest in a total of about 50 stocks. For instance, its portfolio does not contain any stocks from the banking, financial sector and insurance domains. This is a severe constraint for the fund manager. Even with such a restricted universe for stock-picking, Principal's fund has delivered returns of about 2.7 per cent since March 29, 2004. In the same period, a fund such as Franklin India Bluechip has lost about 16 per cent — clearly highlighting the benefits of diversification.

The last couple of months have underlined the benefits of diversification in more ways too. For instance, till the end of April, the rupee was strengthening against dollar. In April, it also strengthened against the euro. Things since then have become topsy-turvy in the Indian markets. The rupee has depreciated quite a bit and staying invested in a foreign currency — which is what investing in overseas stocks means — has worked wonders.

For a better solution: But could the performance of Global Opportunities Fund have been better? Principal's performance is certainly better when benchmarked to that of Morgan Stanley Capital International's World Index. It could, however, have been even better had it the ability to invest outside of the 50 stocks it is now forced to restrict its investments to.

For instance, the fund could have considered exposure to oil stocks, which are the beneficiaries of the surge in oil price. No petroleum sector stock, however, figures in the portfolio of Principal's Global Opportunities fund. It can thus be safely said that returns for active investing would have been still better between end-March and now had the investment universe been much larger for Principal Global.

In this context, any proposal to allow mutual funds to invest in Index funds would only be a halfway house, although passive index fund investing are certainly worthwhile. Indeed, a greater proportion of funds in the US under-perform the S&P 500 Index.

The costs of managing an index fund are also substantially lower than that of an actively managed mutual fund. Still, given the performance of Principal Global, active investing too needs to be given its due.

Choices for investors: Choosing the option of diversification in terms of geographical regions is a risk-averse measure. Any risk-averse measure will continue to deliver lower returns over a longer period. Despite the superior performance of Principal's fund, this is unlikely to change over a longer term.

The returns would be higher only if you time your exit or lower your exposure to other geographies at the right time. That would be necessary to take advantage of any bull-run in the Indian market. Over a longer period of five to ten years it is likely that the Indian market will deliver superior returns to markets of most developed countries.

So, if you are a passive investor in equity mutual funds seeking higher returns, avoiding global mutual funds and staying invested in a diversified equity scheme, still seems a better option from a longer-term perspective. Alternatively, you could wait for an appropriate fund of funds or equity scheme that invests in all geographies.

The manager of such schemes will be in a far superior position to rebalance the portfolio to take advantage of performance-enhancing opportunities that various geographies provide. You may not need to wait too long for that too since Indian fund-houses actively innovate.

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