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For MF investors, window to the world gets wider

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For mutual fund investors, the opportunities to diversify by investing abroad have increased, with the Securities and Exchange Board of India (Sebi) hiking overseas investment limit of domestic fund houses by 65% to $1 billion (overall industry limit remains at $7 billion). Each mutual fund (MF) can also invest up to $300 million in overseas exchange-traded funds (ETFs). The overall limit remains $1 billion.

The windows to the world have been opening rapidly for investors. Just six months ago, the fund house cap was doubled to $600 million and the ETF limit quadrupled to $200 million.

Fund houses have been quick on the uptake. As many as 16 of the 53 international schemes in the market today were launched after March 2020.

So, why should you consider diversification?

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Diversification helps investors ride volatility better and weather different market seasons. For better understanding, let us look at the correlation of Indian and overseas equity markets over the past 10 years. A CRISIL Research analysis (see graphic) shows a weak positive correlation that varies across markets. A correlation above 0.80 is deemed strong, whereas the correlation of the S&P BSE Sensex ranges from 0.05 (versus the Shanghai Composite) to 0.53 (vis-a-vis the Straits Times Index).

Lack of strong correlation implies another index is doing well when Indian indices are not, which means investors can ride the other market’s rally as long as it lasts.

So, how can you take exposure to foreign equities?

A resident Indian can invest in foreign equities either by buying those directly or taking indirect exposure through mutual funds. The direct route has an investment limit of $250,000 per annum in foreign equities under the Reserve Bank of India’s liberalized remittance scheme. The indirect route is more convenient as domestic funds take exposure to funds managed or stocks listed on exchanges outside India. This route allows investors to participate in themes such as energy, mining and commodities—so far unavailable in India.

But two things bear close watching.

Currency movement: The performance of international funds is impacted by currency as well as mark-to-market (MTM) movements of underlying constituents. It is positively impacted by depreciation of the domestic currency. For instance, if an investor put 1 lakh in an international fund on 1 March 2018, when the rupee conversion rate was 65.16 per US dollar (1,000 units @1 unit per US dollar) and exited on 31 May 2021, when the conversion rate was 72.62 per US dollar, he/she would have gained 7,460 [1,000 units x (72.62-65.16)] on account of the conversion factor, assuming there were no MTM gains/losses from the investment. The exact opposite is likely, too.

Taxation: Although international funds invest in different asset classes, including equities, capital gains arising out of these are treated similar to those of debt funds and taxed accordingly. Capital gains for a holding period of less than three years are treated as short-term capital gains, added to the income of the investor and taxed according to the applicable tax bracket. On the other hand, gains over a holding period of more than three years are classified as long-term gains and taxed at 20% after indexation.

And never, ever lose sight of the basics.

The euphoria around international funds isn’t without reason. These funds sure help spread the risk and enable participation across geographies, currencies and varying market conditions.

One should not forget the basics, however. The commandments, therefore are: invest as per your risk profile, investment objectives and time horizon; ignore greed and fear; and conduct essential due-diligence before taking the leap.

Piyush Gupta is director, funds research, CRISIL.

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