Geographical Diversification – A Key Risk Management Strategy

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The first step for any investor is to get used to Equity Markets. As an investor gets used to the volatility and growth features of Equities, he also realises that most of his investments in Equities go up and down at the same time. The magnitude of going up and down may differ across different types of his investments, but they will all behave in the same manner in mid to long term. The following chart demonstrates the movement of investment values on a yearly basis for reasonably good performing investment schemes in India for last decade. You would perhaps note a trend that all of them are materially moving in the same direction, baring a few exceptions.

10 Year returns of mutual fund schemes
(Source : Morning star, Banyan Financial Advisors)

Mathematically this can be reflected in form of Correlation between individual investment and the portfolio as a whole. Any correlation number close to between 0.70 to 1.00 indicates that an investment is highly correlated to each other or in other words, it has a possibility to move in same direction. All the schemes mentioned above have a correlation of close to 0.95.

Correlation between the 5 schemes
(Source : Morning star, Banyan Financial Advisors)

As the portfolio value starts to become material, the next challenge posing infront of an investor is to identify a way to break this positive correlation amongst different investments which he holds in the portfolio. In order to do so, an investor has following options available :

  • Gold
  • Debt
  • Geographical Diversification

Gold and Debt are good options to risk manage the portfolio, but post tax returns may not always be higher than Equities. For an investor with a reasonably long term investment horizon, a different geographical investment option may be a good way to risk manage the portfolio.

Of all the geographies, one of the more stable options which stands out is USA. Lets see how this can assist in risk managing the portfolio without compromising the features / return profile of an Equity investment. We have added two US focused Funds into the investment mix to study the impact :

10 Year Investment Returns, Including US Diversification
(Source : Morning Star, Banyan Financial Advisors)

The same graph as earlier, but now with two US funds show a very evident outcome. You would notice that the bars for Franklin US Opportunities and NASDAQ100 ETF funds do not follow the same return patters as other Indian markets focused funds. For example, in the years 2013, 2015 and 2018-19, while Indian markets weren’t doing too good, the US focused funds were in healthy positives. Also, in 2014  and 2017, while Indian markets were doing extremely well, US too enjoyed the party.

Mathematically again, it will be very evident that US funds have close to zero correlation with Indian markets focused funds. For example, Motilal Oswal’s NASDAQ100 Fund (#7) has <0 correlation with Indian funds, but a moderate correlation with the other Franklin US Fund.

Correlation between Investment Schemes – Including US
(Source Morning Star, Banyan Financial Advisors)

Why is this happening ?

One may ask that why US markets behave differently to India ? The answers could be many, but the top 2 ideas which come in my mind are:

  1. The export / import patter of US is quite different to India. One thing which stands out is – India imports more oil (rather a lot of oil) compared to US and hence is more susceptible to oil price shock.
  2. If INR depreciates against dollar, India being a net importer may be immediately impacted on all fronts where Indian imports, while benefit where it exports. This will start bumping up the cost of imports which will rapidly translate into higher inflation, higher interest rates, higher cost of production and lower demand.

Foreign Exchange Gains

This is an interesting advantage of investing in a country backed by US dollars. The 10 year chart of USD/INR will show that 1 USD to INR moved up from 46 in Feb 2010 to 71 in Nov 2019, a move of approx 6% CAGR. For a shorter period from Nov 2014 to Nov 2019, it moved from 61 to 71, a move of CAGR 3.2%.

USD INR Chart (Source Investing.com)

Historically, India tends to depreciate against USD at an average rate of 3.5% to 5%. If you invest in USD denominated assets, over and above the gains in the value of the assets in USD terms, you will also get an exposure of movement in USD prices. If history holds true in future, it may translate into foreign exchange gains of around 3%+ CAGR.

Taxation

The one thing which takes away some excitement from overseas investments from India is ‘Taxation’. Investing in foreign equities is not treated at par with investments in Indian Equities. Such investments attract taxation similar to a Debt Fund, i.e. after 3 years it will qualify for Long Term Capital Gain status and tax rate of 20% post indexation. Post 10% taxation on Indian equities, the gap between overseas equities and Indian equities has reduced to some extent, but the gap still exists to bite a portion of the gains.

Countries for Geographical Diversification

You may pick your choice at a first level by having a country which has lowest correlation with India. In the chart below the numbers represent following regions :

Correlation between China(1), Wider Asia Excl Japan(4), Brazil (5),Europe 2&6, Wider US (3), US NASDAQ (7), India Sensex (8)
(Source : Morning star, Banyan Financial Advisors)

If we overlay Correlation with the Volatility (risk) and Returns for last 3 years, my choice tends to steer towards # 7, i.e. US NASDAQ which is highly concentrated with technology companies. This could be an option for investors who can consider higher volatility (risk). For lesser volatility, investors could settle with #3, i.e. Wider US which has more balanced set of industries.

Geographies which I could ignore are Brazil (#5) and Europe (#2 & 6) where the risk – reward relationship is not attractive enough.

Risk Reward linkage where X axis is volatility (or risk), Y axis denotes Mean returns
The numbers in the bubbles denote > China(1), Wider Asia Excl Japan(4), Brazil (5),Europe 2&6, Wider US (3), US NASDAQ (7), India Sensex (8)
(Source : Morning star, Banyan Financial Advisors)

Our Conclusion

Based upon all factors mentioned above and ease of investing via the existing fund options in India, we have bottled down our favourite geographical diversification to US. We will continue to monitor the list of options available in India in future and update this blog post.

Note – None of the schemes mentioned in this blog are an investment recommendation from us. They have been used purely to analyse the attributes and compare different geographical options available in India. Please contact your financial advisor for identifying an option for you.

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One Reply to “Geographical Diversification – A Key Risk Management Strategy”

  1. Shailesh Sharma says:

    Excellent analysis. I mostly agree with the views with a couple of caveats

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