Should you invest in offshore funds?
The exuberant bull run of the equity markets in the year 2006 and 2007 introduced investors to several offshore funds. Fund houses were just banking on the investor confidence across the globe, and launching various kinds of offshore funds - some focusing on the Indian-China story, while other taking the broader perspective of international opportunities. For mutual fund distributors too, it was an era of boom - they were simply making hay while the sun shined; as they earned attractive commissions for pushing such funds. All of them in the sheer excitement strongly persuaded many of you investors to invest in offshore funds by creating an overt picture of a global economic boom. And not resisting to their talks many of you in the sheer exuberance did invest in the breed of mutual funds named "offshore funds".
How various offshore funds fared?
NAV data is as on May27, 2011. Standard Deviation and Sharpe ratio is calculated over a 3-Yr period. Risk-free rate is assumed to be 6.37%)
But later the global boom story turned out to be a gloom and doom story as the U.S. sub-prime mortgage crisis emerged, which led to a cripple and ripple effect across the U.S. as well as other parts of the world. Moreover, the belief of "too big to fail" was also debunked once one of world's largest bank - Lehman Brothers went bust. The memories of global economic meltdown of 2008 were deep-etched in the minds of lot of investors as well as policy makers. But in all this mayhem, there was lesson to be learnt. A lesson which teaches, that too much of exuberance (as seen in the year 2006 and 2007) and over-optimism can be bad. It taught "how to smell a rat", when everyone gets foolishly bullish.
Equity markets around the world which were all riding on the exuberant bull run (in 2006 and 2007) had got into the grip of the bears, and our markets too didn't react any differently. The BSE Sensex too went into a bear phase for little over a yearand erodedwealth for you investors' as it (BSE Sensex) gave a return of -55.4%. All the so-called promising themes too were hurt - be it banking & financial services, infrastructure, consumption, capital goods etc. Several companies in a move to trim cost, retrenched individuals and gradually the economy too stepped into an intermediate recessionary phase. But, fortunately due to prudent policy measures taken by our Government as well as the Reserve Bank of India (RBI), we didn't suffer the pain for a very long-time andonce again we started reporting appealing Q-o-Q (Quarter-on-Quarter) GDP growth rate, corporate earnings and of-course a bull run in the Indian equity markets.
But while the Indian equity markets (the BSE Sensex) have gained since the end of the bear phase (i.e. from January 9, 2008 to March 9, 2009) by 43.8%, have your investment in some of those popular offshore funds created that excitement. Have they created wealth for you?
(Source: ACE MF, PersonalFN Research)
Well, if you observe the table above you'll be able to evaluate that over a 3-Yr time framethey have created wealth, but the returns aren't very appealing as against the excitement created by your mutual fund distributor or even the business channels. In fact the returns are far lesser than what a risk-free instrument such as a bank Fixed Deposit (FD) would have yielded. Also from a risk-return perspective, they have been medium risk-low return investment proposition. The very fact that the portfolio churning is low, also reflects the fact that the fund managers had got stuck in some stocks and they entered in them at much elevated levels of the equity markets.Mind you, itin no way reflects the competence of the fund managers in keeping the portfolio churning ratio low.
Performance across market cycles
(Source: ACE MF,PersonalFNResearch)
The table above also reveals that when the equity markets around the turned turbulent led by the economic mayhem in the U.S. (in 2008), these popular offshore funds plunged heavily due to the impact of global crisis, and even later when the Indian equity markets caught the bulls by their horns they lagged when compared to the broader indices such as BSE-200, BSE Sensex and S&P CNX Nifty.
While assessing the lacklustre performance you may be infusedby the feeling of being betrayed, it is vital to recognise that why this happened. Well this is because most of these funds due to their peculiar asset allocation in equities - both domestic as well as foreign (see chart below) were battered when the global economic crisis emerged.
Asset allocation towards domestic and foreign equities
Total assets as on April 30, 2011
(Source: ACE MF,PersonalFNResearch)
Moreover, you simple got swayed with the flagrant excitement created by your mutual fund distributor, and forgot to understand what are offshore funds and the inherent risks of investing in them.
Please note that while offshore funds are typically structured to take economic advantage present in respective foreign nation(s), there are some of the inherent risks involved while investing in them which are:
Apart from the aforementioned risk, one also needs to be well versed with the taxation issues governing offshore mutual funds, which can prompt you to take prudent investment decisions. Mind you offshore funds which have an exposure to foreign assets would be classified as debt mutual funds for the purpose of taxation in India. Hence as an individual your short-term capital gains in them would be subject to tax at your personal income tax rate, while the long-term capital gains too will be taxed at the rate of 10% without availing the indexation benefit or 20% by availing the indexation benefit. However the dividend income which you receive will be exempt from tax, as available for other equity schemes.
- Country-specific macro-economic risk: While you think that you are diversifying across countries and taking exposure to their macro-economic advantage, you need to be ready to assume the country-specific riskto such an investment decision.So for instance if you are investing in a fund which looks at investing in emerging economies, you and your fund manager need to be well versedwith the risks inherent in the emerging economies.
- Currency Risk: A country's currency is vulnerable to an appreciation or depreciation depending upon demand and supply mechanism off-course, but also the policy stance taken by the Government and their central / federal bank. The financial health of the economy is also a matter of concern for the currency to pave its path.
- Regulation risk: Sometimes the regulatory environment also acts as an impeding factor, even though the country offers strong growth potential as an investment destination. This is because investment in foreign securities is subject to nature of securities market and the transaction procedures of the relevant country. The liquidation of investments may also have an adverse impact on the performance of the scheme.
- Geopolitical risk: The political environment may also display its impact on the investment climate. This is because the impact of the policy frameworks carried out by the Government in power will display a macro-economic impact, which in turn would be linked to the fortune of an offshore fund.
Hence considering the above facets, it is vital that you have an understanding of cross-border research - both economic as well as political. Yes, while you may want to de-risk your domestic mutual fund portfolio by taking advantage of the economic synergy in foreign countries (which intend to offer high growth and other fundamental strengths), you need to ensure that you allocate only a very small portion bearing in mind that such investmentforms a part of your satellite portfolio. Also in our opinion while investing in offshore funds, prefer those which take broader exposure to international opportunities or emerging markets as a whole, rather than acute country-specific exposure.
PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.
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