Why you should invest some of your funds in foreign equity and what are its benefits?

The Indian bellwether stock market index has surged close to 1,600 points or 20per cent in the past twelve months, and with it, a number of domestic equity funds have raced ahead too. Many experts believe that the Indian Equity markets have now turned the corner from "broad based rally" to "stock picker's market" . In such a scenario, there might be a case for achieving geographical diversification by investing a portion of your moneys into International Mutual Funds .

ALSO READ: How many mutual funds should you own?

First and foremost, a cursory understanding of the three broad types of International Mutual Funds is warranted. The first, which can really be described as "hybrid" international funds, allocate at least 65per cent of their portfolios to domestic equities, and up to 35per cent of their portfolios into international stocks. Templeton India Equity Income Fund and Birla Sun Life International Equity Fund (Plan B) are examples of these. The second category of international funds employs a 'feeder' mechanism to collect funds locally and deploy them internationally, completely into foreign stocks of a specific region (for instance, Reliance US Equity Opportunities Fund). The third allocates funds to global equities, but based on a specific theme - popular themes include Gold Mining, Agriculture and Energy. DSP BlackRock World Energy Fund and DSP BlackRock World Gold Funds are examples of the third category.

ALSO READ: Why should you review your financial portfolio?

Mutual Fund taxation norms stipulate that a fund must invest at least 65per cent of its assets into listed domestic equities for its tax treatment to be as an "equity fund". Hence, the first category of international funds scores highest from the standpoint of tax-efficiency, since their returns become tax-free after a year. In addition, their dividends are tax-free from day one.

International Fund Performances & Drivers

ALSO READ: Here are 3 stocks that may shower you with gains this monsoon

Understandably, the performances of International Funds have varied wildly depending upon the timeframe, theme, and geography in question. For instance - the NAV of Kotak World Gold Fund, a feeder fund into Falcon Gold Equity Fund, has dropped by 19.08per cent in the past year, whereas Mirae China Advantage Fund has delivered stellar returns of over 26per cent in the same period. However - a 3-year timeframe tells us a different story. Of the 60 international funds with a 3-year plus track record, only two have provided double digit annualized returns. As many as 23 have delivered a negative 3-year CAGR.

Investors who are considering investing into International Funds need to bear in mind that they have a unique set of risks intrinsic to them. First, there's the risk of the target country's currency depreciating during your investment timeframe, leading to an equivalent loss in the rupee value of your units. Second, there's the risk of the fund's target country itself underperforming. Together, these two risks can potentially create a double whammy effect on returns. A case in point is the beleaguered HSBC Brazil Fund, which has delivered a 5-year annualized return of -7.26per cent.

Why International Funds warrant a place in your portfolio

Despite their risks, we believe that International Funds do warrant a place in your portfolio at this time. Valuation-wise, Indian equities aren't exactly cheap anymore, and various signs are pointing to the fact that we may already be in the mid-stages of the current bull run. A smartly selected International Fund can help balance out the risk in your portfolio by hedging you against a fall in the Rupee versus the Dollar, and by strapping on an additional layer of diversification outside of Indian assets. Additionally, some mature markets such as the U.S are generally more stable and trade at 3-4X lower earnings multiples than domestic indices; they can help stabilize your equity portfolio and smooth out your long-term returns.

ALSO READ: First time investor? Here's why you should go for large cap stocks over small and mid caps
 
The Bottom Line

Selecting the right International Fund portfolio can be a tricky task, and new investors with modest portfolios should ideally steer clear of them and opt for SIP's in domestic equity funds instead. Chasing historical returns or shying away from an International Fund based on past returns can both end up backfiring. At the very least, novice investors should avoid the second and third categories of International Funds, while making small & incremental investments into the first kind that combine domestic and international equities in a tax-efficient manner.

If you're a savvier investor with a keen understanding of how domestic and global equity markets work, you could consider a 10-15 per cent allocation to International Funds. Chinese Funds, despite their stellar one-year returns, may have become too risky for comfort at this point. U.S is still considered well balanced in terms of risk and reward, whereas Japanese markets hold potential, with the country having implemented a three-pronged strategy for economic growth; comprising of fiscal stimulus, monetary easing and structural reforms.

Use International Funds as a supplement to your core portfolio of domestic funds. Don't go overboard in your allocation to them. Let's not forget the wise words from the master Warren Buffet himself - "Risk comes from not knowing what you're doing". In all fairness, we'll always be privier to market influencers that are closer home.

The author is the Chief Information Officer for FinEdge, a financial advisory firm