International Eq Funds - Go global to diversify portfolio

For most investors, portfolio diversification is one that includes securities or mutual funds across asset classes, i.e., equity, debt, gold, etc based on their risk profile. Geographical diversification is conspicuous by its absence. Investors can look at international funds to reduce risks and enhance returns via diversification across geographies, currencies and different market conditions. Currently, 17 fund houses in India offer this choice.

These funds are available across developed and emerging markets as well as under different fund management styles, viz. active and passive management. Investors who have fully diversified their portfolios across domestic funds can look at geographic diversification as per their risk-return requirements.

The benefit of investing in international funds can be seen in Table 1. Developed market equities (indices) performed better than emerging market equities in the bear phase (2008 and 2011) while emerging market equities outperformed in a bull phase. Thus, global diversification of one's portfolio through a selection of international equity mutual funds not only reduces risks in a bear phase but also enhances returns in a bull phase. These funds are professionally managed by Indian registered mutual funds that directly invest in foreign securities or overseas mutual funds (which in turn invest in foreign securities).

For investors who want to protect their portfolio from market uncertainty, exposure to developed market indices via mutual funds provides an ideal hedge. Similarly, investors looking for higher returns can look at investing in emerging markets/ high-growth economies like India. As seen in Table 2, developed market funds gave higher returns or declined less in the volatile periods (2011 and 2008), while emerging market indices scored higher in bull period (2007, 2009, 2010 and 2012 YTD).

International Funds - Risk factors

1) Currency risk - Underlying securities in international funds or investments in mother funds are made in foreign currency, which makes them vulnerable to the currency risk. This was seen in recent times when the dollar appreciated sharply against most emerging market currencies, with the domestic rupee reaching historic lows. For example, if an investor invests Rs 50,000 in an international fund when the rupee conversion rate is Rs 50 per US dollar (1,000 units @ 1 unit per US dollar), and exits when the conversion rate is Rs 54 per US dollar, the investor's gain on account of the conversion factor would be Rs 4,000 [1,000 units * (54-50)], assuming there are no mark-to-market gains/ losses. However, on the negative side, the appreciation of the rupee can result in capital loss.

2) Country/ geo-political risks - International funds will always be subject to country-specific, economic and geo-political risks. Some international funds invest only in one country, hence any political or economic problems in that country will have a negative impact on the performance of these funds. For e.g., the economic dishevel caused by a tsunami and nuclear crisis in Japan in February 2011 impacted its market severely compared to other global markets.

3) Tax treatment - International funds which invest at least 65% in Indian stocks and the remaining in international markets are categorised as equity funds and, accordingly, enjoy tax benefits. Short-term capital gains are taxed at 10% for these funds while long-term capital gains are tax free. All other types of funds in this category are taxed like debt funds, where the long-term gains would be taxed at a flat rate of 10% without indexation or 20% with indexation. The short-term gains will be added to the investor's income and will be taxed as per the applicable slab rates. Hence, investors must understand the structure of the international fund to know the tax implications.

Conclusion
International funds allow investors to reduce risks and increase returns via diversification across geographies, currencies and different market conditions. Investors can choose to invest in emerging markets or developed markets as per their risk profile and investment objectives. Investors who prefer active management, should look at international fund of funds or pure international funds. For passive investors, the ETF route for international funds will suffice. However, investors should invest in international funds only after having diversified their portfolio in the domestic mutual fund market first.

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