One question that always crosses the mind of most investors in India is whether or not to have some exposure to international markets in their portfolios. Today, some major Indian mutual fund houses provide means to invest in international markets through some of their product offerings. So convenience is less of an issue for investors with regard to investing in foreign markets. Moreover taking on exposure to foreign markets in our portfolios can offer benefits that we would not be able to enjoy with a portfolio that is solely exposed to domestic markets.
Also, the fact that major global equity indices such as the S&P 500 and the Dow Jones Industrial Average, and most markets the across the world have fallen sharply over the past few months seemingly make a compelling case for investing in global markets. That being said, there are still a number of factors that Indian investors fail to consider before deciding whether or not to have some exposure to international markets in their portfolios. So today I am going to throw light on what those factors are and what considerations we must make before deciding on the inclusion or exclusion of foreign exposure in our portfolios. I will also talk about the most ideal avenues through which to include foreign exposure in our portfolios.
The primary reason why all of us invest is to be able to consume. In other words, the achievement of each of our financial goals allows us to consume something. For example when we invest to buy a house or vehicle, we invest to be able to buy the asset in question which we can then make use of. When we invest in our children’s education, we invest to consume a service (namely education) at a certain point of time in the future. And when we invest for retirement, we invest to be able to consume the lifestyle of our choice at a certain point in the future for a certain number of years into the future.
Therefore the first consideration to be made when considering whether or not to invest in foreign markets is our the place where we are likely to enjoy most of our consumption. If we are likely to consume mostly within India, it would be better to run a portfolio that is predominantly exposed to the Indian markets. If on the other hand we are likely to predominantly live and consume outside India, or spend equal amounts of time within and outside India then it would make sense to have relatively higher exposure to foreign markets, especially to the markets of the country we reside in when we are outside India.
In most cases we may hold multiple asset classes in our portfolios, or multiple components within a single asset class. In such cases rebalancing becomes an important factor we need to consider. Let's say an investor holds equity, debt and gold at the asset class level in their portfolio with an asset allocation of 60:30:10 respectively. Also assume they build their equity portfolio with a 80:20 allocation to a Nifty 50 index fund (Indian) and a S&P 500 INR ETF (US) respectively. Effectively, the amount allocated to the Nifty 50 index fund would be 48 (60 * 80%). And the amount allocated to the S&P ETF would be 12 (60 * 20%).
Given that the portfolio has been structured in this way the investor needs to ensure that they maintain their equity mix at 80:20 over and above having to maintain their overall portfolio mix at 60:30:10. Also, if the Indian and US equity markets were to move in opposite directions, their equity portfolio would become lopsided. And as a consequence, their portfolio as a whole would become lopsided. Therefore the complexity involved in rebalancing their portfolio would increase. Those of us who cannot handle such complexity should refrain from taking on significant exposure to foreign markets.
Most Indian investors think that investing in global markets would boost their overall portfolio returns. But we first need to verify whether or not this notion is backed by a reasonable base of facts and data. The graph below charts Sensex returns and S&P 500 returns in INR terms against the USD-INR exchange rate from 1996 to 2022. (The S&P 500 has been chosen for comparison with the Sensex because the S&P 500 is one of the most robust and widely preferred foreign indices among Indian investors).
It is clear from the graph above that at the end of the period under study the returns from both indices keep pace with exchange rate fluctuations despite volatility along the way. Now, a comparison of the returns of both indices shows that returns from the S&P 500 remained flat for a prolonged period between 2002 and 2012. This goes to show that the possibility another prolonged period of flat returns in the future cannot be ruled out. Therefore, investing in a foreign market index like the S&P 500 need not necessarily boost portfolio returns.
But in terms of adding another layer of diversification to our equity portfolios and reducing portfolio volatility international exposure may have a strong case. This is also borne out in the graph where the severity of drawdowns in S&P 500 are much lower than those in the Sensex. But it should also be kept in mind that lower volatility may also translate into lower returns. So that is another tradeoff investors would have to consider when making this decision.
All things considered, it may not be of harm to have foreign exposure to the extent of 20-25% of our equity portfolios. Those who wish to include exposure to foreign markets in their portfolios must also be aware of the product options through which to gain such exposure. The first of these options would be select flexi cap mutual funds which hold international stocks to the extent of 20-25% of their portfolios. But as with any other actively managed mutual fund, investors would have to live with the presence of fund manager risk. Investors also have the option of purchasing an Exchange Traded Fund (ETF) that tracks indices such as the S&P 500 or the NASDAQ.
The major risk here is the fact that both these indices are overly exposed to certain sectors such as technology, meaning concentration risk would be high. Investors may also consider the option of opening an overseas brokerage account which would allow them to invest in overseas securities directly. But considering the costs involved in opening and managing such accounts, it may not represent a viable option for most investors. Finally, investors also have the option to invest in foreign markets through feeder funds.
Exposure to foreign markets in an investment portfolio is something that is nice to have. But it is not a must have. In other words, most investors would be just fine with investment portfolios that are solely exposed to domestic markets. There is no single number that can be considered as an optimal amount of exposure to foreign markets. But 15-25% of exposure to foreign markets would not hurt investors. But what is important is that investors who include foreign exposure in their portfolios do so after fully understanding the demands and implications of doing so. Only then would they be able fully leverage the benefits of including foreign exposure in their portfolios.