Ask any finance professional 'should investors diversify their investments?' The answer will be a resounding yes. Diversification is a key risk mitigation strategy. Generally, we view diversification as investing in unrelated asset classes. However, diversification also means spreading your risk across geographies.
Usually individuals invest all their savings in their home country. This exposes investors to country risk. That is any negative economic or political event in the country affects their investment returns. A way to shield your clients against country risk is to invest internationally.
Investing directly in foreign markets requires expertise and is subject to investment limits. However, investors planning to diversify internationally can do so via the mutual fund route.
Let us understand the pros and cons of investing in foreign funds.
- Risk mitigation - Helps in providing portfolio diversification
- Broader investment basket - Your clients can gain exposure to strong international businesses which are not listed in India
- No limit – RBI has imposed certain restrictions on direct foreign investments. However, there are no such restrictions on investments made through foreign funds. As per RBI guidelines, the annual overseas investment ceiling for individuals is US $250,000 (approx. 1.7 crore).
- Planning for foreign education – Children of many clients dream of studying in a foreign university. Being well aware of the foreign education costs many parents save for their children’s education. However, these savings do not adequately reflect the impact of currency on investments. To elaborate assume the year is 2008, your clients calculate that they need to save 50 thousand dollars that is 21 lakhs for their son’s education over a period of 10 years. USD/INR was around 42 in 2008. Come 2018 Rupee has depreciated to 68 that is a change of 61%. Now the same amount 50 thousand USD translates to 34 lakh Rupees. This huge increase will turn the client’s financial calculations on its head. Instead if the client would have invested in a foreign fund investing in US markets then the currency movement would have no impact on the client’s financial plan.
- Increased global risk - The client portfolio is exposed to country specific risks of all economies in which the international fund invests
- Currency risk – This is the main risk while investing internationally. Any movement in Rupee compared to the currency of underlying investment influences scheme performance. An appreciating Rupee negatively affects the returns while a depreciating Rupee boosts returns.
- Tax inefficiency - For tax purposes, they are treated as debt funds. Earlier when long term capital gains tax (LTCG) for equities was nil foreign funds were at a significant disadvantage. However, this disparity has reduced post budget as the Government has reintroduced long-term capital gains (LTCG) tax on equity investments.
Now, profits (above one lakh) from equity investments where the holding period is more than a year are taxed at 10%. While, long-term investments in foreign funds (holding period greater than three years) are taxed at 20% with indexation benefit.
International funds can be categorised in two different ways:
A. Based on portfolio construction
- Schemes investing directly in foreign equities – The local fund manager selects good quality international companies for investment. You need to evaluate track record of the scheme before recommending it to clients.
- Funds investing in international mutual fund scheme (feeder fund) - The fund invests in an international fund (generally of the parent company) managed by an overseas fund manager. Before recommending the scheme, you need to look at the performance history of the overseas fund.
- Funds investing in international mutual fund schemes (fund of fund) - The fund can invest in multiple international funds. In case of foreign fund of funds, you have to screen all schemes in which the fund invests to gauge it growth potential.
- Schemes predominantly investing in Indian markets but taking up to 35% exposure to foreign equities – These are essentially domestic funds which diversify their portfolio by adding international exposure. As they invest at least 65% of their assets in the Indian equity market, they are taxed like equity mutual funds.
B. Based on investment basket
- Global funds – They invest across economies and sectors. They are diversified funds in the truest sense.
- Sectoral/Thematic funds – They invest in a particular commodity, sector or theme such as gold, real estate. Your clients can gain exposure to uncommon themes like mining, agriculture by investing in these funds.
- Region specific funds – They invest in a particular country or geographic region. Investors can participate in growth stories of different emerging economies like China, Brazil or developed economies like US by investing in these funds.
Before recommending international funds to clients, you need to evaluate growth potential of underlying economies and businesses. In addition, you have to educate your clients about currency risk.