Building a portfolio that is resilient to negative economic factors is important for earning consistent returns and preserving wealth. A key factor to achieving this resilient portfolio is diversification. A savvy Indian investor will likely hold a portfolio that is diversified across asset classes (equity, bonds, gold and so on), industries (pharma, real estate and so on), and time (systematic investment plans or SIPs that invest in the markets at different points in time). But one of the key pillars of diversification that is missing in most of our portfolios is geography.
Diversifying geographically helps reduce country as well as currency risk. The rupee has annually depreciated on an average about 4% against the US dollar over the last 10 years. So while your portfolio might have given great returns in terms of rupee, the returns would not look pretty on a global level. The easiest way to understand the impact of the currency depreciation is to look at the returns of the Sensex versus the Dollex (the US dollar version of the Sensex). Over the last 10 years, the Sensex has given an absolute return of 135%, whereas the Dollex has returned 51%.
So, when diversifying geographically, which economies should one look to invest in? Naturally, the idea of investing in other emerging markets seems intriguing. These emerging markets are poised to grow rapidly in the coming years, and rising GDP is, typically, accompanied with rising income. This tempts investors to assume that the local stock market in these countries will also flourish. This is a trap that one should avoid. GDP is a measure of economic growth and not a true indicator of financial market growth. Let’s look at a simple example—as the income level of Indians goes up and results in increased streaming consumption via Netflix and Spotify, the growth generated in India will not be reflected in the local markets, since these companies are publicly traded in the US.
Thus, GDP growth alone is insufficient as a stand-alone indicator, especially for emerging markets. In fact, if you plot GDP growth against stock market returns for different countries over the last three years, there is poor correlation between GDP growth and stock market returns. Fast-growing Southeast Asian countries such as Vietnam, Philippines and Indonesia averaged returns between 0.68% to 20% over the past three years, despite their real GDP growing over 5% per year on average.
A couple of emerging markets, apart from India, that have performed well in the last few years are China and Brazil. Both the markets, which are part of the BRICS association, are definitely worth taking a closer look at. Despite the ongoing US-China trade war, China’s stock market performed well—up 23.9% in 2019. However, one contentious practice that has artificially boosted the profits of China’s public companies is government subsidies. In 2018, the Chinese government gave subsidies that amounted to 5% of the net profit earned by China’s public companies ($22.4 billion), in 2019, they increased it by another 15%. Further, the Chinese stock market is notoriously volatile since it is largely based on retail investors’ activities. On the other hand, despite slow economic growth (the real GDP growth was only 0.9% in 2019), the Brazilian index (Bovespa) gained 24% last year. Investor sentiments in Brazil are bullish. A combination of low interest rates, low inflation and continuing economic reforms from the current administration are expected to bolster the economy.
So, as someone living in India, how do we get exposure to these emerging economies? The easiest and most cost-effective way to actually do it is to invest through exchange-traded funds (ETFs) on the US markets. You can invest in them by opening an account with a US broker. This type of investment is possible under the Liberalised Remittance Scheme (LRS) of the Reserve Bank of India (RBI) up to $250,000 per annum. For example, BlackRock’s iShares has an ETF that invests in Chinese mid- to large-cap companies. The expense ratio of this ETF is only 0.59%. And, if you would not want to indulge in country-picking, there are ETFs that invest in most of the emerging markets. For example, BlackRock’s EEM or Vanguard’s VWO. There are now platforms available that allow you to invest in the US markets from India in an easy manner.
As part of the Union Budget 2020, the government has proposed to introduce a 5% tax collection on transactions done via LRS beyond a total of ₹7 lakh or approximately $10,000 in a year. This tax collected will be available as credit to the payer when they file their taxes. The 5% can also offset any capital gain taxes that would need to be paid in India on foreign investments. Further, details on this announcement are still awaited.
All in all, geographic diversification is key to building a resilient portfolio. Investing in emerging markets beyond India provides a great opportunity to diversify country risk and still earn decent returns. But one needs to be careful not to be swayed by the promise of high GDP growth since it might not necessarily translate into high stock market growth. Lastly, the easiest way to invest in these markets is to hold low-cost ETFs listed on the US exchanges.
Viram Shah is co-founder and chief executive officer, Vested, a US SEC-registered investment adviser
