Author: shyam

Diversification vs. Returns vs. Currency hedging

Some Indian funds, under the guise of diversification, invest in foreign equities. However, the benefit of diversification comes from investing across asset classes. Does investing in the same asset class, i.e., equities, really give the investor uncorrelated returns? Or are funds using international equities as a rupee-short in disguise?

World Equity Correlation

When you run correlations between the monthly returns of the S&P 500, Nasdaq, FTSE 100, Nikkei and CNX 500, here’s what you get:

A zero or negative correlation would validate the diversification claim. But that is not the case. Indian equities are loosely correlated with international stock markets.

World equity Returns

When it comes to returns, Indian equities have outperformed all the main indices.

Currency hedge

The 50% depreciation in the rupee since 2000, however, make a strong case for adding short-INR/long-USD assets.

Competency

Although Rupee depreciation makes a case for holding dollar assets, why do it in a convoluted way by buying individual stocks? The competency of an Indian asset manager in picking stocks in a foreign market is questionable.

For example, the PPFAS fund holds about 20% of its assets in foreign equities. This, at a time when most developed markets have given up on stock-picking and have turned to indexing instead. Can a manager, sitting in India, select stocks in a foreign market that outperform that market?

The problem with a mixed-in portfolio like PPFAS is that it is very difficult to break performance down to its components. Between 2014-01-01 and 2015-02-25, PPFAS Long Term Value Fund has returned a cumulative 44.20% with an IRR of 37.45% vs. BSE MID CAP’s cumulative return of 58.84% and an IRR of 49.50%. (http://svz.bz/1DZzX1L)

Conclusion

Exposure to US Dollar assets makes sense given the historical depreciation of the Indian rupee against the US dollar. However, we are not convinced that buying a fund that tries to pick stocks in foreign markets is the way to go. Investors would be better of being net short the rupee, or buying the S&P 500 ETF separately.

Churn and Burn

When retail investors trade stocks, the market impact of trading decisions are de minimis. However, when a fund trades its portfolio, it has a noticeable market impact. According to a study quoted here in the Economist article, when academics compared the returns of the funds with their estimated trading costs, the funds with the highest costs had the lowest returns.

For contrast, lets compare the DWS Tax Saving Fund with Templeton India Growth Fund.

DWS Tax Saving Fund

First, investors would have been better off buying a CNX Midcap index fund. Between 2006-06-01 and 2015-02-19, DWS TAX SAVING FUND has returned a cumulative 143.52% with an IRR of 10.74% vs. CNX Midcap’s cumulative return of 209.71% and an IRR of 13.83%. (http://svz.bz/1EHGTxu)

Second, the fund looks like a fun trading vehicle for the manager rather than something that is meant to build wealth over the long term. Here’s how the manager has churned his portfolio:

Not only should you stay away from this fund, but you should use it in informational videos on how not to churn your portfolio.

Templeton India Growth Fund

First, even though returns are not the absolute best that it could have been, between 2006-06-01 and 2015-02-19, Templeton India Growth Fund has returned a cumulative 267.72% with an IRR of 16.09%.(http://svz.bz/1EHIljm)

Second, the portfolio doesn’t look like a mad scramble like the one above. Markedly fewer holdings for longer:

When you compare the two funds with each other, you can see who is doing a better job (http://svz.bz/1EHJCa2):

Conclusion

Beware of funds that churn their portfolios frequently. It might be a reflection of shoddy research, poor conviction or immaturity that you end up paying for.