Globally equities have gone through a lot of volatility in the last couple of years. We saw a major downcycle event (Covid-19) with markets correcting 29% and a major rally where equities bounced back swiftly to touch all-time highs around the start of 2022. Recently, markets felt the jitters as the tension between Russia and Ukraine escalated to war. This shifted investors’ sentiment globally.
The MSCI All Country World Index (ACWI) saw a drawdown (fall from peak to trough) of 10.6% from its January 2022 peak. Indian equities also took the brunt due to an upswing in commodity prices, particularly oil and industrial metals, leading to risk aversion and concerns of 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.
How can an investor limit the downside risk?
One can well reduce the risk by diversifying to defensive assets like cash and fixed income. However, current low or negative real rates i.e., after adjusting for inflation – don’t make it lucrative enough for investors to park money.
History suggests, that investing in global equities along with local market exposure has helped investors generate wealth at low risk as drawdowns are lower for a globally diversified portfolio vs India equity-only portfolio. 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%. If we extend the period, during the global financial crisis (GFC) of 2008, the global equities had corrected by 46% and Indian equities had corrected by 66%. Needless to say, equities as a growth asset bounced back strongly from both major falls.
There are a couple of reasons that justify lower drawdown by investing in global equities.
1) From a fundamental diversification perspective, we strongly believe that global investing gives 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 over the last decade, outperforming India by a hefty margin which delivered 14.9%. This has led to a lot of interest generating among retail investors to participate in global equities, particularly U.S. equities.
There are funds domiciled in India through which investors can diversify into global equities. Pre-covid (February 2020) the global funds’ category assets were trailing at Rs 4,200 cr and as of March 2022, the assets have grown to Rs 38,000 cr; of this around Rs 22,000 cr is invested in U.S. equity funds. The retail investors truly latched upon U.S. equities, the hype around FAANG 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 says mutual funds can make overseas investments up to $1 billion 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 didn’t 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 under international funds. As a result, investors flocked to few international ETFs listed on NSE and BSE. Again, given that fresh units can’t be created due to restrictions, the investors can only manage to 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 ETFs performance divergence from the index that it is tracking. Look at the performance of ETFs from Feb 1 till Apr 27, 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 performance and could lead to further deviation. New investors will end up paying a higher price as compared to the price of the underlying index. Given the performance divergence is wide, it could result in a course correction once the restrictions are lifted, negatively impacting investors.
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 the 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.
Is there any valuation opportunity in global markets?
Emerging Markets (EM) have underperformed the ACWI Index which has been influenced 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%) which was triggered by regulatory crackdowns. The correction in EM has led to a widening valuation gap between India and EM, making EM and China, in particular, a lot more attractive purely 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 do take away the opportunity to participate in global equities where equity market valuations are attractive. Given the lack of an alternate investment route for retail investors to participate in global equities, they need to stay on the sidelines till the time investment limits are enhanced.