Mit­i­gate do­mes­tic risks by in­vest­ing abroad

Open a low-cost in­ter­na­tional broking ac­count and in­vest in low-cost in­ter­na­tional ex­change-traded funds

Business Standard - - YOUR MONEY - AV­INASH LUTHRIA The writer is a Sebi-reg­is­tered in­vest­ment ad­viser and founder, Fidu­cia­ries

Over the past few months, the for­eign ex­change mar­ket has joined the In­dian bond mar­ket in im­ply­ing that de­spite the Mon­e­tary Pol­icy Com­mit­tee’s ef­forts, In­dia will not meet its com­mit­ment of lim­it­ing con­sumer price in­dex (CPI) in­fla­tion to 4 per cent till March 2021. But even if In­dia were to have high in­fla­tion of 5-7 per cent over the long term, the do­mes­tic eq­uity com­po­nent of one’s port­fo­lio is likely to par­tially mit­i­gate this over the long term, that is, over many decades. How­ever, nei­ther do­mes­tic eq­uity nor do­mes­tic real es­tate can be re­lied upon to mit­i­gate sev­eral coun­try spe­cific tail risks.

Noted fi­nan­cial the­o­rist Wil­liam J Bern­stein cat­e­gorised such deep risks as in­fla­tion, con­fis­ca­tion, devastation and de­fla­tion. In­fla­tion in­cludes very high in­fla­tion or hy­per­in­fla­tion, as seen in Ar­gentina and Brazil around 1989. Con­fis­ca­tion could be overt or covert. Overt con­fis­ca­tion be­comes more likely as a coun­try be­comes less demo­cratic, while covert con­fis­ca­tion in­cludes very high tax rates. Devastation is pri­mar­ily caused by war, in­clud­ing a ma­jor ter­ror­ist at­tack. And fi­nally, there is de­fla­tion, the rarest cat­e­gory of risk, as wit­nessed in Japan in 1989 and Greece in 2013. Such tail risks are too rare to at­tach prob­a­bil­i­ties to, but they are nev­er­the­less rel­e­vant.

Di­ver­sify to re­duce risks: In­ter­na­tional in­vest­ments, in­clud­ing eq­ui­ties, of­fer bet­ter, though not com­plete, mit­i­ga­tion against some of these coun­try spe­cific tail risks. The pri­mary rea­son one should in­vest in in­ter­na­tional eq­ui­ties is to di­ver­sify one’s risk by not putting 100 per cent of one’s net worth in one coun­try, In­dia, which con­trib­utes just 3.3 per cent of world nom­i­nal GDP. None of us would be will­ing to put 100 per cent of our net worth in Italy, which is an econ­omy of a com­pa­ra­ble size. This is de­spite Italy’s S&P sov­er­eign credit rat­ing be­ing one notch higher than In­dia’s. In­dia’s credit rat­ing in­ci­den­tally is one notch above junk.

The sec­ond rea­son is that though In­dia’s eq­uity re­turns are highly cor­re­lated to world eq­uity re­turns over the short term (years), over the long term (decades) that cor­re­la­tion is likely to be much lower. In­dia’s to­tal (that is, in­clud­ing div­i­dends) and real (that is, net of in­fla­tion) eq­uity re­turns over sev­eral decades pro­vide an il­lus­tra­tion. Since re­li­able long-term to­tal real re­turns data for In­dia does not ex­ist, the fol­low­ing is a rough es­ti­mate. Over the past 33 years, since the launch of the Sen­sex, In­dia’s re­turns have been close to US re­turns. But if one looks at the past 80 years, then In­dia’s re­turns have been dras­ti­cally lower than US re­turns (this is based on data from ‘Global Stock Mar­kets in the Twentieth Cen­tury’ in The Jour­nal of Fi­nance in June 2002 by Philippe Jo­rion).

The ideal op­tion: Since In­dia’s mu­tual fund in­dus­try is still ma­tur­ing, ideal op­tions don’t ex­ist. How­ever, a hy­po­thet­i­cal ideal op­tion pro­vides a base­line to com­pare the ac­tual op­tions against. The hy­po­thet­i­cal ideal op­tion is an In­dian low­cost (ex­pense ra­tio about 5-10 ba­sis points a year) feeder fund that in­vests in the Van­guard US S&P 500 ETF (whose ex­pense ra­tio is 4 ba­sis points a year), or the equiv­a­lent in­dex fund.

The only bear­able op­tion then is the Van­guard US S&P 500 ETF through a for­eign broking ac­count. To avail of this, one needs to first open a low-cost for­eign broking ac­count di­rectly from In­dia. Such a broking ac­count’s cost (min­i­mum guar­an­teed rev­enue for the bro­ker) of $10 per month sub­jec­tively makes it ideal for some­one who ex­pects to have cu­mu­la­tive in­vest­ment of at least ~5 mil­lion through this route, over the next five years. The sec­ond step is to trans­fer funds from In­dia into the broking ac­count in the US un­der In­dia’s Lib­er­alised Remit­tance Scheme (LRS). The fi­nal step is to stag­ger the pur­chase of the Van­guard US S&P 500 ETF over sev­eral years.

This route has three im­por­tant tax-re­lated dis­ad­van­tages. One, your In­dian in­come tax re­turns will be­come more com­pli­cated be­cause you will be forced to sep­a­rately dis­close all for­eign as­sets and in­come. Two, In­dia’s am­bigu­ous tax laws force one to as­sume that US ETFs will be taxed like US eq­uity shares. Ac­cord­ingly, if one holds such US ETFs for more than 24 months, then af­ter in­dex­a­tion ben­e­fit one will have to pay cap­i­tal gains tax at a rate of around 20 per cent. Three, while this route cur­rently does not ob­jec­tively in­crease the risk of a tax scru­tiny, these rules could change in the fu­ture. Such a tax scru­tiny would dis­tract the in­vestor from his job or busi­ness. Hence, an in­vestor think­ing of tak­ing this route should con­sult a char­tered ac­coun­tant about all these three tax­a­tion-re­lated as­pects.

High cost of In­dian feeder funds: If you use one of the feeder funds avail­able in In­dia that in­vest in US eq­ui­ties, you will en­joy a few ad­van­tages. Your tax fil­ing will not be­come more com­plex. You will also en­joy clar­ity that your in­vest­ment in this fund will be taxed like a debt mu­tual fund. It will also elim­i­nate any pos­si­ble fu­ture risk of tax scru­tiny. But the com­bined cost of the largest such feeder fund through a direct plan to­gether with the un­der­ly­ing ac­tively man­aged fund is around 186 ba­sis points per an­num (as of Septem­ber 18, 2018). To achieve any di­ver­si­fi­ca­tion, the in­vestor will have to put in at least one-fourth of his net worth in in­ter­na­tional eq­ui­ties. How­ever, the high cost of such schemes makes them un­suit­able for such a large pro­por­tion of one’s net worth.

Com­pen­sate through as­set al­lo­ca­tion: But what if an in­vestor is not will­ing to in­vest out­side In­dia, or is un­able to be­cause his net worth does not jus­tify the cost? In that case, he can­not par­tially mit­i­gate these tail risks. But he should still try to com­pen­sate for this through his as­set al­lo­ca­tion. For ex­am­ple, an in­di­vid­ual who is not will­ing to in­vest out­side In­dia may have to limit him­self to a lower eq­uity al­lo­ca­tion com­pared to an equiv­a­lent in­di­vid­ual who is will­ing to in­vest out­side In­dia. Also, for such an in­di­vid­ual, any ex­po­sure to In­dian mid- caps or small- caps in­creases the risk fur­ther and is coun­ter­pro­duc­tive.

Ideally, an in­vestor should di­ver­sify out­side his home coun­try, which in our case is In­dia. And if he does not, then he should try to com­pen­sate for this through his as­set al­lo­ca­tion.


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