Asset allocation and diversification are considered to be the holy grail of investing. Adding non-correlated assets to one’s portfolio is supposed to reduce volatility and hence encourage the good behavior of staying invested through market cycles. Here, we look at a simple two asset portfolio and work through some simple scenarios.
Picking the Assets and Allocation
When one looks historical inflation adjusted returns (link,) an investor with a 10+ year horizon should be invested in midcaps. So we pick the NIFTY MIDCAP 100 index and the 0-5 year bond total return index as the assets for our simple allocation setup.
The most popular allocation for an equity/bond portfolio in literature is 60/40 in favor of equities. However, we will go through a range of scenarios where the equity allocation is stepped through from 40% to 90% in increments of 10%
After picking the assets and their allocation, we need to figure out what would trigger a rebalance. Should we rebalance whenever the weights go off by 5% or should we wait until they drift 20% from their initial allocation? We will step through this as well – from 5% to 100% in increments of 10%
And lastly, the question of capital gains and securities transaction tax. Tax incidence on these two asset classes have varied over time. So for simplicity, we will assume an STT of 0.1% and a capital gains tax of 10% applied whenever a rebalance occurs.
The results
As one would expect, higher the risk taken, higher the cumulative returns. What changes are the drawdowns. Here are the various allocations, assuming a 20% rebalance threshold and with/without the tax drag. Note the different drawdown profiles at the bottom of the chart. Without taxes: After tax:
And here are the historical returns of the 60/40 portfolio:
As intuition would suggest, the more frequently you rebalance, the higher your tax incidence. But keeping the rebalance threshold too high would allow a single asset to balloon and make the portfolio too sensitive to it. As show in this table, historically, keeping a rebalance threshold at 20% has worked out well for a 60/40 equity/bond portfolio.
Code, charts and the complete result dataset are available on github.
Indian investors have a significant home bias – we tend to hold a high proportion of our portfolio, sometimes 100%, in Indian assets. However, if you look at how the rupee has behaved vis-a-vis the US Dollar, the advantage of international diversification becomes obvious.
USDINR has been a one-way trade
Historically, the rupee has only depreciated against the dollar. It is the price we pay for being a socialist democracy with poor fiscal responsibility and an unaccountable central bank.
Depreciation quantified
Nifty investors have seen an IRR of 821% since 1991 and today. However, in dollar terms, the IRR is 286%. The difference of 535% is because of rupee depreciation – even if you had held on to a non-productive dollar asset, you would have made that much in rupee terms.
Diversification benefit
By being long only Indian assets, your fate is tied to the vagaries of the local market participants, regulators and politicians. In a country where most people have dual-SIM phones, it is surprising that most investors are willing to hitch their ride to that pony.
One of the oldest international funds is from Birla Sun Life, let us see how that fared since the financial crisis:
Between 2008-01-01 and 2015-06-15, Birla Sun Life International Equity Fund Plan A- Growth has returned a cumulative 69.99% with an IRR of 7.37% vs. CNX Midcap’s cumulative return of 32.36% and an IRR of 3.83%. It has a beta of only 0.12825 vs. the Midcap index. (MorningStar)
Caveats
The biggest problem with investing in international funds is manager competence. All the reasons we highlighted in our post, Funds that (also) invest in foreign markets, apply. At the end of the day, you are still investing in equities and equity markets are (loosely) correlated. However, investors are better off choosing a pure international equity fund rather than one where the “international” part is a hobby.
The second problem is that there are some funds that invest in emerging Asia or frontier markets. These funds are not really long the dollar. Investors should pay attention to this detail.
Conclusion
Investing in international funds makes sense from a depreciation and diversification point of view. In our Aggressive Fund portfolio, we assign 30% of investor allocation to international funds.
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There are quite a few reasons why Indians would want to invest overseas. Education, retirement and emigration are frequently cited as top priorities. In the past, the only way to do this was through the Liberalised Remittance Scheme (LRS) route. However, with Indian mutual funds finally waking up to increasing demand from investors, does investing in international public market securities through this process still make sense?
Liberalised Remittance Scheme
The Indian Government, through its various regulatory and enforcement arms, have traditionally tried to keep Indians from sending money abroad. The problem has always been that populist policies used to win elections end up choking growth and stoking inflation. This leads to investors pulling funds away from India – aka, capital flight. One way to stem the tide is to try and trap Indian capital within India.
We use the word “try” because we are all aware about the hawala network that thrives to this day because of these policies. Thankfully, the process of liberalization has slowly, in baby steps, opened the doors for Indians to legally remit funds abroad.
The Reserve Bank of India (RBI) sets the rules governing these fund transfers that banks need to follow. And banks are supposed to report and track these transactions both at the individual and aggregate levels. Given the paperwork involved, most banks require you to make a trip to a “designated” branch office and execute the instruction in-person. The whole process is cumbersome, requires paperwork and takes an hour or two to complete.
Not only is LRS is painful, it is also expensive.
Most people fixate on bank fees and GST but that’s only part of the story. The biggest scam is the exchange rate given by the bank – it is the worst possible rate that they can give you while still being compliant with rules & regulations. If you compare the “google” rate with the final transfer rate, you’ll find that the drag is about 3%
So, why do it?
More Choice, Less Cost
The US ETF market went through a decade-long price war that drove vanilla cap-weighted fees to almost zero.
For example, if you want to invest in the S&P 500 index, then Vanguard’s VOO ETF charges you 3bps for the privilege whereas Motilal’s index fund charges 50bps. If you consider the tax differential and the transfer knee-cap, you break-even by year 7. So, if you are a passive, buy & hold investor with a long enough time horizon, LRS makes more sense.
While costs are important, so are choices. You can access strategies beyond what Indian mutual funds deign to offer in the local market. For example, there are a ton of factor strategies available through ETFs that are probably never going to be launched in India.
Indian policy makers love to ape Western European policies without giving a second thought to its appropriateness given our stage of growth. One such self-goal has been the STT – Securities Transaction Tax – that taxes transactions rather than profits. And yes, we tax both short-term and long-term capital gains. Sort of like a dare: We’ll see how you’ll make money trading.
Fortunately, the US has avoided shooting itself in the foot so far.
Lets say, you fall in the 30% income tax slab. You have a trading strategy that makes 20% returns in both markets. The strategy turnsover the portfolio “x” times. Given 0.01% STT in India and zero brokerage in the US, what is “x” for you to be indifferent in Year 1?
If you turn over your portfolio more than 60 times, you would be better off deploying that strategy in the US rather than India.
If you set the gross returns to zero, the required turnover drops to 30.
However, if you only trade infrequently, then LRS may not the best way to go. For example, a 40x turnover strategy will need 3 years to be indifferent.
Basically, if you are going to trade frequently, doing it in the US makes a lot more sense.
Caveats
LRS ensures that you will need a Chartered Accountant to do you taxes. You need to account for the dividends you have received, report your net personal assets, etc. So this route doesn’t make sense for small accounts.
If you don’t share your trading and banking passwords with your next-of-kin, then you need to be worried about US Estate laws. The U.S. has jurisdiction over U.S.-situated assets and requires executors for nonresidents to file an estate tax return if the fair market value at death of the decedent’s U.S.-situated assets exceeds $60,000. Directly investing in U.S.-situs assets as a non-U.S. investor creates potential U.S. estate tax liabilities.1
Conclusion
We feel that the LRS route is attractive both for a buy & hold investor as well as an active investor with an edge. However, one should get into it knowing the trade-offs involved.
If you are looking for simple, pre-canned investment strategies to invest in the US, check out freefloat.us
For the longest time in the US, actively managed mutual funds ruled the roost. Then came Jack Bogle with his index fund and the ceaseless mantra of “costs and taxes matter” and the dynamic shifted, slowly at first and then suddenly, in favor of indexing. It was only a matter of time before people figured out the tax loophole of ETFs and now, there are over 2500 ETFs listed in the US.
Unlike in India, where mutual funds are “pass through,” US mutual fund investors pay capital gains tax on assets sold by their funds. When there are large-scale redemptions, say, during a market melt-down, funds are forced to sell their holdings. This generates capital gains taxes, meaning that investors have to pay tax on assets that had fallen sharply in value1.
ETFs, on the other hand, don’t have to subject their investors to such harsh tax treatment. ETF providers offer shares “in kind,” with authorized participants serving as a buffer between investors and the providers’ trading-triggered tax events.
A Plethora
Of the ETFs that survive today, the number of launches every year has trended higher.
While Equity ETFs dominate launches, the share of fixed income, alternatives, etc. has increased as well.
Most of the AUM resides in “vanilla” strategies – typically market-cap based.
The winner HAS taken all
Plot the assets of each ETF, in billions, in log-scale and you can tell that this is a game of scale.
Of the total 2577 ETFs, 2022 (78.5%) have less than a billion dollars in assets. You need to filter for $10 billion and up to just see the x-axis.
The top 3 issuers: Blackrock, Vanguard and SSGA manage ~80% of all ETF assets.
Where there is an ETF, there’s an Index
Until last year, ETFs were supposed to be a “passive” entity. There were no “actively managed” ETFs. In order to be passive, an ETF needed to follow an index. And indices had to be rules based – however convoluted the rules. And issuers needed a third-party to provide the index.
The rise of ETFs (and passive investing, in general) put index providers in the middle of all the a action. They became a crucial cog in world finance that can make or break entire economies. So powerful, in fact, that China blackmailed MSCI to include its domestic stocks in its Emerging Markets Index, which is tracked by close to $2 trillion in assets2. And India has been working on inclusion of Indian sovereign bonds in global bond indices3.
We can see industry consolidation here as well. The top 5 index providers control ~75% of ETF AUM (more if you include index funds.) S&P Global and MSCI are as close to “pure-play” index providers as you can get and their stock market performance is off-the-charts.
Fee Squeeze and Innovation
The problem with index ETFs/funds is that buyers only care about two things: expense ratio and tracking error. This resulted in a massive fee war that saw the vanilla-passive industry consolidate around Blackrock and Vanguard. For example, Vanguard’s S&P 500 ETF’s expense ratio is 3bps.
So, what next?
International ETFs
The first wave was ETFs providing international diversification. However, the “home-bias” is pretty strong with AUM under international ETFs barely making a quarter of the total.
On a weighted average basis, these ETFs charge about 30bps. However, since these are mostly cap-weighted, the fee-war is just as intense here.
Leveraged/Inverse ETFs
Many investors have mandates that prevent them from trading derivates outright. This is especially true for Indian investors taking the LRS route to invest in the US. However, Wall Street has your back.
Leveraged ETFs give you 2x or 3x the daily returns of a benchmark index like the S&P 500 or the Nasdaq 100. Feeling bearish? Inverse ETFs do the opposite.
Caveat: These are NOT buy-and-hold investments and are more suitable for day-traders. The discussion requires a separate post.
On a weighted average basis, these ETFs charge about 100bps. While lucrative, they are mostly niche.
Active ETFs
An ETF’s tax-free wrapper make it an order of magnitude more attractive than an identical mutual fund. New issuers/managers have taken advantage of this and launched actively managed ETFs.
On a weighted average basis, active ETFs charge about 50bps. These are still early days for this category – they barely make 5% of total ETF assets. Liquidity and tracking errors during market crisis are yet to be tested.
Conclusion
There is a plethora of choices when it comes to ETFs in the US. If you plan to wander away from the plain-vanilla stuff, please take the time to read the prospectus and understand how it works.
If you are looking for simple, pre-canned investment strategies to invest in the US, check out freefloat.us
