Tackle political risk by investing abroad

Opt for passive funds for the long term and bet initially on first world markets

Over the past 20 years, the Nifty has a very high correlation to the MSCI Emerging Markets Index. Annual returns have a correlation of around 0.8, which implies that the Nifty moves in the same direction as other emerging markets (EMs) most of the time. The Nifty’s correlation with the US Dow Jones Industrial Averages or the NASDAQ 100 is lower, at around 0.5, though it’s still significant.

So far, calendar 2019 has bucked correlations. Every major stock market in the world is up, and many have given double-digit returns in 2019. The one exception is India. What’s more, India is also among the most expensive markets in the world, with average index valuations in the price-to-earnings (PE) range of 26 or higher. The rupee has also fallen about 9 per cent year-on-year against the US dollar.

This lack of correlation and bearishness is partially a pre-election effect. Investors have been cautious and will continue to be so until the next government is in charge. It is also a rational investor response to disappointing earnings growth and a never-ending non-performing assets crisis.  A near-war situation will make them even more cautious.

The non-correlation underlines the validity of advice that savvy money-managers have been giving for a while to the effect that Indian investors should diversify abroad. The instruments to do this already exist. There are multiple funds, and “feeder funds”, available in rupees and covering various parts of the global economy. A resident Indian can also buy foreign equity directly though that requires a fair amount of paperwork and a lot of research.

Economies have cycles. So do elections. Unfortunately, India’s economic growth is highly dependent on sensible policymaking and competent administration, and there is no guarantee that either will be provided by any given government.

External hedges are useful since political risk can affect every segment of the economy. Moreover, an external hedge helps manage the currency risk, which is also pretty significant. So, creating an overseas component to the portfolio should be a no-brainer. When it comes to investing abroad, some factors could be worth considering. The average investor has neither the time nor the expertise to study local businesses in any detail. It’s even harder to make sense of overseas plays. Timing these is also very difficult, assuming you want to even try timing overseas assets.

Given that, passive fund-based investing seems to be reasonable. And like all passive fund-based investments, it should be done for the long-term. Diversification is also likely to be a good strategy, but it’s up to the individual to figure out what exactly diversification means.

Should you focus on a fund that gives broad coverage of sectors across just the US economy? Or should you look for funds that offer coverage of several national economies? Should you look at Emerging Market coverage or hard currency First World coverage?

There can’t be definitive answers but here are the things to consider. Hard currency businesses will offer a hedge for the falling rupee, and India is less correlated to the US, Eurozone and Japan, than to emerging markets as a class. So there’s a fair chance that a hard-currency focus will offer better defensive prospects for the long-term investor at times when the India cycle is down.

But EMs are more likely to produce higher, long-term returns, coupled with occasional bursts of extreme underperformance. Those downtrends may, very likely, coincide with Indian bear markets, given the high historical correlation. So an EM-heavy portfolio wouldn’t be a hedge. Specific EMs – the nations which are energy-surplus, for example – could provide hedges, however.

Most EMs are also traded at lower valuations than India.  However, in terms of valuations, hard-currency stock markets generally trade at much lower valuations compared to India, or other EMs (because first world economies usually offer lower growth prospects). While all markets are cyclical, the swings and volatility is less extreme in First World markets. This is another point that could be of potential comfort to a long-term investor.

The next several months will be a roller coaster for India, and there are no guarantees about the shape of the next government. But the advice to diversify abroad goes well beyond that time frame. Historical data suggests that diversifying abroad could be a smart long-term decision and one that will pay through the next five years to a decade.