Should you invest in International Mutual Funds?

International funds have caught the attention of many investors in recent months, needless to say why.

International funds, specifically those investing in the US equity markets have delivered better relative returns over the last 10 years, supported by strong growth in US economy and relatively poor show by Indian equities. Depreciating Indian rupee has also played a role in this.

Decision to invest in an asset class has to based on 5 basic principles – Diversification benefits, your understanding about the asset class, alignment with your expectations in the long run, taxation and opportunity cost. If the asset class ticks most of these boxes or the ones which you think are most important for you, then investments in such asset can be considered.

Now let’s see how international funds score on each of these principles for a common Indian investor.

Diversification benefits – International funds, specifically those investing in the US equity markets have low correlation with Indian markets, this definitely adds diversification benefits to the portfolio. However, some international funds investing in emerging markets may not have such benefits due to multiple reasons. They fall and rise along with Indian markets most of the time due to common source of capital flows.

Understanding the risks – No asset class is immune to risks. International funds carry multiple risks – home country risk, currency risk and geo-political risks. Most importantly, a common investor may not be on top of all these factors at all times and may be completely unaware about them most of the times. Understanding of  international markets in general is poor among many investors.

Alignment with expectations – Over last one month we have come across many investors who want to invest in international funds. When we asked them why they want to invest, the most common answer was obviously returns. Even people who said diversification, were mostly trying to justify their own bias. The bias which was already built by looking at returns. A guy who is investing since decades didn’t learn diversification benefits of international markets just today.

Anyways, if your expectation from such international funds is that they shall repeat their last 10 yr performance over next 10 years, then your expectations are misplaced. We are not saying they won’t, but also not necessarily they will. India has more growth potential and in long run (given all other factors remain same) a high growth country should deliver better absolute returnscompared to a low growth country.

If your expectations are genuinely to diversify your portfolio using low correlated assets then the alignment is correct.

Taxation – These funds are taxed as debt mutual funds and provide indexation benefits on long term capital gains after 3 years. Indian equity funds have an advantage over international equity funds when it comes to taxation. While we personally think taxation is not a very important criteria if you are investing for long term (as tax rules can change), but one should not ignore them either.

Opportunity cost – Investing is all about choosing one asset class over other to optimize returns given the amount of risk you take. International funds may not be less risky than Indian equities, they may be less correlated with Indian equities, but they do carry similar if not more risk. They are equities after all.

In fact we would rate them higher in terms of risk as they carry an additional risk – currency risk. Though Indian currency has been depreciating due to inflation difference, this may not be true in some years and cycles. There can be years and cycles when Indian currency may appreciate, mostly in years following sharp depreciation, like we have seen in recent months.

We invest in equities to generate inflation beating returns. In the long run, domestic equity returns are linked to domestic inflationary trends and hence, are most suitable for achieving this very basic goal. So if you are choosing international fund over Indian equities, look for that opportunity cost. Don’t go by last 10 years returns.

To conclude…for most investors international funds may not be needed as they don’t tick most of the boxes of basic principles alluded above. The opportunity cost can be high. Those looking for genuine diversification needs can invest, but not significant portion.

Remember, in investing, most of us are at an advantage by choosing simplicity over complexity in our portfolios.

Disclaimer: This post was originally written by TheMFguy and has been reproduced here (with certain minor edits) with his kind permission.