International Investing for Indians: The Local Options

Today, there are multiple ways for Indian investors to diversify their portfolio across international markets. These can be divided into two broad groups:

1. Local, India-based: Foreign assets are held and managed by the Indian mutual fund companies.
2. Direct Investing: Self-managed, through a foreign brokerage account.

India-based Options

1. Mutual Funds
2. Exchange Traded Funds (ETFs)
3. Fund of Funds (FoFs)

Mutual Funds

Several mutual funds in India invest directly and solely in international markets. These funds are not too different from the others—the only distinction is that they hold shares of companies listed outside India instead of those of Indian companies.

And like their more well-known counterparts, these funds too can be active or passive in their management approach. But most are actively managed. The passive ones aim to replicate well-known indexes such as the S&P 500, NASDAQ 100 or MSCI EAFE.

Whether active or passive, these funds tend to focus on a single geography—think the US, Europe, China etc. For instance, ICICI Prudential US Bluechip Equity Fund, Edelweiss Europe Dynamic Equity Offshore Fund, and Nippon India Japan Equity Fund are active funds, while Motilal Oswal MSCI EAFE Top 100 Select Index Fund is passive.

The major advantage of these funds is their convenience. You can invest in them easily through the fund companies’ website or any of the MF distribution portals like Kuvera, Groww etc.

Exchange Traded Funds (ETFs)

Mutual funds are not your only option though. Several ETFs listed on the Indian stock exchanges too hold only international stocks. You can buy these ETFs just like any other India-listed shares, via brokers like Zerodha. But unlike mutual funds, you need a Demat account to hold these ETFs.

As of February 2024, India-listed ETFs focused on foreign investments are passively managed and aim to replicate major indices like the S&P 500 or NASDAQ 100. The passive style helps keep the expense ratio low.

Buying and selling these ETFs, however, incurs significant transaction costs because of thin trading volumes. The bid-ask spreads are pretty wide and the price often deviates significantly from the underlying NAV. The low volume also makes it hard to do large transactions. It is also not easy to set up SIPs to invest in ETFs as not all investment platforms support the feature.

Fund of Funds (FoFs)

Yet another option are Fund of Funds (FoF). FoFs are wrapper mutual funds that hold units of other ETFs or mutual funds, which, in turn, hold the stocks. The underlying fund(s) could be listed in India or abroad.

The hybrid fund structure benefits investors by a) making popular International mutual funds and ETFs easily accessible and b) eliminating the transaction costs and low trading volume-related issues that affect India-listed ETFs.

As FoFs are a type of mutual fund, you can directly transact with the mutual fund company. As a result, there’s no bid/ask spread penalty, you can buy/sell as much as you like and you never overpay compared to the underlying NAV. You can invest in FoFs and set up SIPs through the fund company’s website or the MF distribution portals, no demat account needed.

One major disadvantage of FoFs, however, is that the two layers of management (the underlying fund and the wrapper fund) increase costs, leading to significant performance drag.

Also, not all FoFs are created equal: some are structured better than the rest. Other things being equal, FoFs that are based on foreign-listed ETFs tend to have higher returns because the underlying ETFs have lower fee (0.1-0.2% compared to the 1.5%-2% charged by the Indian ETFs).

Some newer FoFs are using UCITS ETFs as the underlying. UCITS ETFs benefit from lower taxation on dividends as they are often domiciled in Ireland, which has tax treaties with several countries. India or US ETFs have no such advantage.

For instance, the age-old Motilal Oswal Nasdaq 100 FoF uses the India-domiciled Motilal Oswal Nasdaq 100 ETF as the underlying. On the other hand, Axis NASDAQ 100 FoF and Aditya Birla Sun Life NASDAQ 100 FOF, which are more recent, are based on the iShares NASDAQ 100 UCITS ETF. Invesco India - Invesco Global Equity Income FoF, however, is based on the actively managed Invesco Global Equity Income mutual fund.

Common Downsides

There are a multitude of issues that affect all the three routes:

• Large Tracking Differences
• Limited Investment Universe
• Industry-wide limits on foreign investments

Large Tracking Differences

All three vehicles have quite large tracking differences¹, often in the range of 1.5-2% per year. These large tracking differences arise due to high expense ratios because of multiple layers of fund management, delays in buying or selling the underlying stocks/ETFs/funds, uninvested cash, and a variety of other reasons. While a 2% drag may not seem significant, you can lose 30%+ of your corpus to fees and inefficiencies over 30 years.

Limited Investment Universe

Despite several recent offerings, the local options for international diversification are still limited. Alternative investment strategies (such as trend following) or innovative ETFs such as $NTSX, $RSST etc. continue to be inaccessible. As most fund offerings tend to be US-focused, it is also hard to diversify across other geographies. If you want to invest in individual stocks, you have no option but to go direct.

Indian fund companies are unlikely to offer sophisticated funds in near future as they will not be popular with the masses.

Industry-wide limits on foreign investments

RBI has mandated a $7 billion limit on overseas investments via mutual funds. When this limit was reached in 2022, RBI temporarily halted all new lump-sum investments and SIPs in these funds. While RBI subsequently allowed fresh investments after a significant crash in the AUM of these funds, the industry-level ceiling still stands and will get hit again in future.

Common Benefits

Despite these issues, there are distinct advantages to adopting one of these local methods, compared to going direct:

• Convenience: If you’re just getting started with your international diversification journey and are not dealing with a large pot of money, the accessibility of these methods and the simplicity of getting started with them trumps their downsides. The minimum investment amounts are also as low as ₹1000.
• Straightforward Taxation and Tax Filing: Calculating and filing taxes on capital gains from funds and ETFs based out of India is straightforward — at the marginal slab rate. One doesn’t need to worry about double taxation on dividends, disclosure of foreign assets and accounts etc.
• Simpler Inheritance: As nomination and inheritance laws are identical to other mutual fund holdings, that is one less thing to worry about.

In the next post , we will cover why it may be better for some to forego these local options and invest directly outside India.