Indian economy has been on a roll for the last 3-4 years. This has attracted huge foreign inflows into India. As such India’s foreign currency reserves have risen from a few hundred million dollars in 1991 to more than 200 billion dollars in 2007. This has emboldened RBI to allow Indian investors to invest in the international markets through MFs.

There was one such fund earlier from Principal, whose objective was to invest mainly in the international markets. However, with the relaxation in the guidelines, Sundaram, Kotak, and Deutsche MFs have recently launched the global market funds. And one can expect many more in this category. (View - New Fund Offers open NOW)

The idea that we explore here is – should we invest in these funds?

Return Expectation

Any investment is made with a view to earning returns.

So what returns can we expect from the global economies and markets?

India is one of the fastest growing economies in the world along with China. Next in line are the countries like Brazil, Russia, South East Asian economies, etc. US, Europe, Japan are mature economies with comparatively lower growth rates; though of course their size is much bigger.

Economic growth gets reflected in the stock market performance. Therefore, given this growth scenario, one can expect good returns from China, Brazil, Russia, South East Asia etc. Though, of course, India is also expected to be amongst the top.

So broadly speaking, yes one can expect good returns from the international markets if the economic growth pans out as per the expectations. This is also borne out by the fact that, like India, these markets too have delivered phenomenal returns in the last 2-3 years in line with the economic growth.

Of course, it goes without saying that the normal equity risk applies to these funds too. Most global funds are presently taking the fund-of-funds route - investing mainly in proven mutual funds abroad, instead of taking direct exposure. This helps to diversify the risk and also contain fund management costs.  

One may, however, argue, that if India is expected to be amongst the top, why invest outside? The answer is simple – market diversification; just as we do stock diversification or asset diversification. It is quite likely that some economies may do well and some may not. For example, if oil prices were to cross US$ 100, India will suffer. But, Russia, which owns a lot of oil, will gain. 

However, there are two issues, which can affect these returns:

• Currency Risk
• Taxation

Currency Risk

Suppose you invested Rs. 50,000 in a global fund on July 1, 2006. To invest this money in the international markets, it needs to be converted into dollars. Assuming that the exchange rate was Rs.45, this would work out to US$ 1111.11. Say after 1 year on June 30, 2007, these markets gave a return of 12%. Thus your investment of US$ 1111.11 would have appreciated to US$ 1244.44.

Now you redeem your investment. Suppose by now the rupee has appreciated and the exchange rate is now Rs.40. Thus, the MF will sell US$ 1244.44 and give you Rs. 49,777.78. Therefore, despite the international market giving you a profit of 12%, you have actually lost money due to currency appreciation.

This is currency risk.

The question, therefore, arises, how real is this risk? Well, till a few years ago, it was quite easy to answer this question. The rupee was always depreciating.

But now this is not so. We have seen rupee appreciating. In fact, had the RBI not intervened, this appreciation could have been even higher.

Given the strength of the Indian economy vis-ΰ-vis other economies in the world, one can expect more and more dollar inflows. Also, given US’s deficit economy, dollar, which is still the major currency for international transactions, is expected to progressively get weaker. Hence, the risk of rupee appreciation is high, which will affect your returns from the global market funds.

Taxation

The long-term capital gains from equity mutual funds in India are tax-free. And the short-term capital gains are taxed at 10%. These very attractive tax rates are, however, not applicable to global market funds.

Global funds are taxed

• @ 10% (without indexation)/20% (with indexation) for Long Term Capital Gains; &
• At your normal income tax rate for Short Term Capital Gains, which could be as high as 30% if you are in the highest tax bracket.

Thus, higher tax rates would eat into your profits from global funds.

To get around this taxation problem, a few funds have been launched which invest 65% in Indian markets and only 35% in international markets. They, then enjoy the lower tax rates. Of course, the currency risk still remains. Also, as they have direct exposure to equity they would be comparatively riskier than the fund-of-fund type global funds.

In view of the foregoing, while one can expect good returns from the international funds, the same could be affected by currency risk and higher taxation. Secondly, Indian markets are also expected to be amongst the top performers. Therefore, such global funds – whether 100% or 35% - can be considered mainly from the point of portfolio diversification, with a small allocation from the corpus.