The Hindu Business Line : Still room for diversification

A noteworthy feature of the recent stock market corrections globally has been their contagious nature. Selling pressure on stocks has been transmitted quickly across geographies, reinforcing the idea that there are close links across various national markets in a globalised and financially networked world. Equally, optimism and even a slight recovery in sentiment has been found to travel quickly, far and wide.

What do these trends of national markets moving in tandem signify? Do they mean financial globalisation has proceeded so far that there is a high degree of co-movement (or correlation) between apparently disparate markets? If various national markets are so closely integrated, what does it imply for investors seeking to diversify their portfolios (and risks) across national markets? What are the prospects for the continuation of (the strong) portfolio capital flows into emerging markets in this scenario?

Diversification under threat?

The diversification benefits (arriving at an optimal combination of risk and returns by not putting all eggs in one basket) which can be obtained by investing in different national markets is probably the most critical driver of global portfolio flows.

The diversification benefits basically arise from the imperfect or weak correlation between asset returns in different countries. Such a weak correlation between diverse markets is mostly on account of the varying economic, industrial and political structures and policies.

Such policy differences imply that business cycles (the most important determinant of corporate financial performance) are not contemporaneous in different countries. An economic downturn in one country and, consequently, tepid corporate earnings could be more than made up for by robust demand conditions and strong corporate earnings performance in another economy.

Probably the most telling example of the non-contemporaneous nature of business cycles in recent times is the uninterrupted growth noticed in the UK economy for more than a decade now. The ‘closely linked’ euro-zone economy, though, has alternated between contraction and expansion in the same period.

Has this foundation of imperfect correlations among local markets been weakened? If so, as apparently indicated by the sympathetic movement of stock indices during the on-going global market correction, how sustainable can portfolio flows be in the ensuing period? For instance, can India, which has been attracting portfolio flows of the order of around $6-7 billion per annum, expect this level of inflows to continue?

Correlations not strong, support portfolio flows

An analysis shows that the potential for portfolio diversification by investing across global markets is still considerable.

A comparative study of the dollar returns of a representative sample of emerging markets and that of the S&P 500 over the past five years suggests that the correlation among national markets is still quite weak — averaging around 0.5 — and this still provides good scope for earning higher risk-adjusted returns by investing across countries.

In the circumstances, the prospects for portfolio capital flows into emerging markets maintaining their momentum of the past few years continue to be quite bright. However, the exercise of finding the nature and strength of the relationship among different national markets is necessarily backward-looking in terms of data reliance and, therefore, cannot precisely predict what is going to happen in the future.

If long-term relationships among various stock markets continue to be weak, what explains the almost one-to-one move in global stocks recently?

Such sympathetic movements across national markets have only proved (yet again) the point that historical relationships among economic variables come under strain and break down during a general crisis.

Such a break-down does not alter or modify the strength of the long-term trend or relationship. Long observed correlations breaking down during crises has been noticed across all asset classes — stocks, currencies, bonds and commodities — as capital withdraws from risky/emerging markets and a ‘home bias’ takes over.

As the Table shows, the S&P 500, taken as a global bellwether, has a correlation, on average, of around 0.5 with some key emerging markets — such as India, South Korea, Taiwan and South Africa.

At 0.5, the correlation is fairly weak — since this means that only 25 per cent of the performance of the relevant emerging markets is influenced by what is happening in the S&P 500, and 75 per cent is determined by individual market conditions/economic performance.

To the US investor — a mutual fund or a pension fund, for instance — such a low correlation between the US and some key emerging markets is the perfect foundation for diversifying his investment basket.

Returns and risks

The Table also shows that the average (dollar) monthly returns for Indian stocks (represented by the Sensex) is the highest among the markets studied, at 3 per cent. But, as can be noted, the risk measure (standard deviation of the monthly returns) is also highest for India, at around 7 per cent.

Compared to the emerging markets, the average monthly return on the S&P is quite low, at less than 1 per cent. But that lower return is also matched by the lower level of risk attaching to those returns. When studying overseas investments, the currency factor necessarily comes into the picture.

As the Table shows, the Indian rupee has been relatively stable in the past five years compared to some of its emerging market peers. At around 4 per cent, it has been quite steady, unlike the South African Rand or the Korean Won, which have been more variable at 16 per cent and 10 per cent respectively.

But the fact that the overall risk measure on the dollar returns of Indian stocks is higher than the other countries’ despite currency risk being lower, possibly shows that other system-wide (and non-diversifiable) risks, in India’s case, are imparting a fair degree of volatility to returns from Indian stocks.

The portfolio capital inflow environment into India appears quite conducive to the extent indicated by the fairly low or weak relationship between the S&P 500 and Indian stocks.

In recent times, with some East Asian countries also turning portfolio investors in Indian markets, the fairly low correlation between the Korean/Taiwanese indices and the Sensex also augurs well for the overall capital inflow environment.

What about the portfolio outflow environment — meaning overseas portfolio investments by Indian residents — mainly through mutual funds?

More leeway for investors

The recently enhanced ceiling on the overseas investments of mutual funds — to $4 billion from $3 billion — provides Indian investors more leeway to reap the benefits of portfolio diversification.

Again, as the Table shows, the Sensex’s relationship with some of the leading emerging markets, such as South Africa, is not very strong. To that extent, there is scope for diversifying investments globally and earning higher risk-adjusted returns.

But the caveat for investors is to be aware of the level of currency risk attaching to particular markets. High volatility in currencies could impact the overall level of stock market returns in a combination of ways.

The overall variability of stock returns in a particular country would be a function of the local currency’s volatility on an on-going basis, the stock market’s returns in local currency terms and how the changes in currency values co-vary with that of local currency stock returns.

Direct hedging of currency risks becomes critical here. (Investment across countries, by itself, could deliver a certain degree of currency risk minimisation.

Direct hedging is over and above the risk minimisation attained indirectly through the markets).

Investors have to probably choose those markets in which hedging facilities/products are fairly well-developed relative to the size/volatility of the underlying currency market and the level of overseas investments.

Overall, the level of idiosyncrasies attaching to individual national markets continue to be notable despite a general global movement towards common economic policies — marked by increased openness to trade in goods and services, greater fiscal restraint or at least an acceptance of fiscal restraint, more independent central banks and increased stress on inflation control, and also greater emphasis on the role of markets in all spheres of economic activity.

The persistence of such individuality continues to keep the prospects bright for portfolio diversification and the necessary capital flows.

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