Globally equities have witnessed significant volatility in the last couple of years. We saw a major downcycle event (Covid-19) with markets correcting 29% in March 2020, followed by a sharp rally where equities bounced back swiftly to touch all-time highs around the start of 2022.
And recently, again, markets felt the jitters as tensions between Russia and Ukraine escalated to war. This shifted investor sentiment globally. The MSCI All Country World Index (ACWI) saw a drawdown (fall from peak to trough) of -10.6% from its Jan 2022 peak.
Indian equities also took the brunt due to a further upswing in commodity prices, particularly oil and industrial metals (commodity prices were already up before the war due to strong demand recovery & supply-side issues), leading to risk aversion and concerns around the de-rating of high earnings expectations.
It is a hard truth of investing that the biggest downside risk to the investor is themselves. While high inflation, market crashes, and pandemics can all create short-term disruptions, permanent damage tends to occur when we make poor investment decisions driven by greed or fear.
How can investors limit downside risk? One can reduce downside risk by diversifying into defensive assets like cash and fixed income. However, current low or negative real rates i.e., after adjusting for inflation – do not make it lucrative enough for investors to park a substantial portion of their money.
History suggests that investing in global equities along with local market exposure has helped investors generate wealth at moderate risk as drawdowns are lower for a globally diversified portfolio vs a portfolio investing only in India equity.
To give a perspective, during the pandemic, MSCI ACWI saw a drawdown of 29% against the S&P BSE 500 index, which was down 38%. Going back in time, during the global financial crisis (GFC) of 2008, global equities corrected by 46%, whereas Indian equities fell by 66%.
Needless to say, equities as a growth asset bounced back strongly from both major falls.
There are several factors that justify lower drawdowns by investing in global equities.
1) From a fundamental diversification perspective, we strongly believe that global investing provides exposure to varied international economic & fundamental growth drivers that responds differently to contingent events.
2) It also provides a hedge against rupee depreciation – adding to the overall asset return. The numbers speak for themselves. U.S. equities have delivered 19.3% annualized in INR terms over the last decade, outperforming Indian equities by a hefty margin which delivered 14.9%. This has led to a jump in retail investor interest to participate in global equities, particularly U.S. equities.
Traditionally Indian investors could diversify into global equities via funds domiciled in India. Pre-covid (Feb 2020), the global funds’ category assets were trailing at INR 4,200 crores and as of March 2022, these assets have ballooned to INR 38,000 crores, of which around INR 22,000 crores are invested in U.S. equity funds. Retail investors truly latched upon U.S. equities, the hype around FAANGM stocks in particular.
Strong inflows into global funds led the regulator to step in, and around the end of January, the regulator advised mutual fund companies to stop further investments in foreign stocks to avoid breach of overseas investment limits set by the RBI.
The regulation states that overseas investments up to $1 billion can be made per mutual fund, with the overall industry limit of $7 billion. The foreign investment limit was widely expected to be enhanced by the regulator. However, as that did not materialize, the fund companies had to stop accepting fresh flows coming in international funds from the 2nd of February, limiting investments only via existing SIPs or STPs.
The situation complicated further as few fund companies decided to stop flows coming from existing SIPs and STPs into international funds. As a result, investors flocked to few international ETFs listed on NSE and BSE. Again, given that fresh units cannot be created due to prevailing restrictions, investors can only buy ETF units that are available on the exchanges.
This led to a surge in demand for international ETFs with supply and liquidity being limited. The outcome is – recent performance of ETFs has seen a divergence from the index that it is tracking. For instance, from Feb 1 till Apr 27, 2022, the Nippon India Hang Seng ETF delivered -0.85% compared to -14.3% delivered by the Hang Seng index that it is tracking. Motilal Oswal Nasdaq 100 ETF delivered -1.71% compared to -10.51% delivered by the underlying Nasdaq 100 index.
This clearly indicates that the ETFs are not correctly reflecting the fall in the underlying index and this deviation could rise driven largely by demand and supply for these ETFs. New investors will end up paying a higher price as compared to the price of the underlying index. Given that the performance differential is wide, it could result in a course correction once the restrictions are lifted, negatively impacting investors.
Why are the investment limits not enhanced? No one would have an answer to this question – leaving it open for market participants to speculate.
Does it make a difference for an investor by not investing in global markets? We believe, certainly, it does make a difference. As explained earlier, it makes sense to fundamentally diversify a portfolio to markets that offer decent valuation opportunities.
As a valuation-driven investor, we aim to identify opportunities in global markets where valuations are below their fair multiple. This helps in lowering the potential for losses and maximizes the potential for returns if markets are trading below fair levels and vice-a-versa.
Are there any attractive opportunities in global markets? Emerging Markets (EMs) have underperformed the ACWI Index that is skewed by heavy losses in China and more recently Russia. On a one-year basis, the MSCI EM Index delivered -21.5% vs MSCI ACWI Index which is down 3.1%. MSCI China Index delivered -41.6% for the same period as Chinese tech giants saw a major correction (-52%) that was triggered by regulatory crackdowns.
The correction in EMs has led to a widening valuation gap between India and EM, making EM and China, in particular, relatively more attractive from a valuation perspective. For US equities, we see two offsetting developments. On one hand, the strength of the recovery is leading to fundamental improvements with corporate profits continuing to rise in most sectors.
On the other hand, we must recognize that much of the recent rally was sentimental optimism, with valuations stretching, creating potential vulnerabilities amid higher interest rates. Taken together, at current prices, U.S. equities still look expensive overall, according to our analysis, both in absolute terms and relative to international markets. However, this view has moderated following recent market falls. Apart from this, Europe and U.K. also offer attractive investment opportunities.
The current regulatory restrictions deprive investors of the opportunity to participate in global markets where equity market valuations are attractive. Given the lack of an alternate investment route for retail investors to participate in global equities via INR denominated products, they need to stay on the sidelines till the time investment limits are enhanced.
Data source: Morningstar Direct
(The author is Associate Director, Capital Markets & Asset Allocation, Morningstar Investment Adviser India)