Two years back, had we suggested that you invest in international funds, you might have jumped at the opportunity. And why not? The year 2007 saw the launch of 12 international funds, of which eight were launched between August and October, when global markets, including India, were touching new highs. In 2007, the Securities and Exchange Board of India (Sebi) raised the overall ceiling for investments in foreign securities by mutual funds to $5 billion.

It did not take long for the fundamental reasons of launching international funds to be tossed out of the window. In 2008, markets collapsed in the US on the back of the credit crisis, and Indian markets followed suit. If you had invested in international funds to protect your portfolio from the vagaries of just one market (India), your strategy would not have paid off as almost all the markets tumbled in 2008.

Does investing in international funds still make sense? Read on.

What are they?

International funds are those funds that invest in international markets. Broadly, there are two types. The first invests partly in Indian and partly in foreign markets such as Fidelity International Opportunities Fund and ICICI Prudential Indo Asia Equity Fund. This lot typically invests at least 65 per cent in Indian securities and the rest in international equities, as income tax rules mandate investments of at least 65 per cent in Indian securities to retain the equity tax advantage.

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Global Market Performance

Historically, the performance of different markets has varied significantly across the globe

Data till 22 Sept 2009 All figures are in per cent

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There are some funds that invest in only one country apart from India, such as Fortis China India Fund and Mirae Asset China Advantage Fund. Both these funds are limited to only one foreign country (China) in terms of their investments.

The second category is of funds that are purely international as they invest their entire corpus internationally, such as Birla Sun Life International Equity Fund and HSBC Emerging Markets Fund. They can invest either in international schemes run by their foreign parents who would further invest in international markets, or they directly buy and sell international stocks.

The potential pitfalls

Currency Risk. While the fund's success rests on the quality of fund management much like any domestic mutual fund scheme, the biggest risk that international funds face is currency risk. The movement of the rupee vs the US dollar––the currency that most international funds solicit investments in––affects the performance of your fund.

To give you a simple example, let's suppose you invest Rs 10,000 in an international fund in India. Assume that your fund invests in US dollars and the exchange rate at the time of investment is Rs 50 to a dollar. You will get equities worth $200. Suppose that after a year, the rupee depreciates by Rs 2 and stands at Rs 52 to a dollar. If your fund redeems its money, assuming that foreign equities have not risen or fallen at all, your $200 would now be worth Rs 10,400 (a four percent gain), purely on exchange rate play. Obviously, the exchange rate can also turn against you if the rupee appreciates. Most global mutual funds are denominated in the dollar. However, as these funds invest in countries around the world, these dollars are instantly converted into local currencies. At the time of redemption, they are converted first into dollars and then to rupees.

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What’s the returns?

Growth rates* of different markets from January 2004 through September 2009

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The real currency risk comes in when the rupee appreciates against the greenback much more than other global currencies. If this happens, your international funds incur a loss. The trick for fund managers would be in anticipating not just the rupee-dollar equation, but also the equations of the greenback with other currencies, especially the Asian ones, since a majority of international funds aim to invest in emerging markets. Says Nilesh Shah, deputy managing director, ICICI Prudential Mutual Fund: “Investing in international funds helps to diversify the portfolio but investors should not forget to see the fund manager's competency and his expertise in managing international funds.”

Country risk. Investing in just one foreign country as against a group of countries is akin to investing in a sectoral fund that invests in just one sector vs investing in diversified equity funds that invest across sectors. There are several micro and macroeconomic and geo-political factors impact a country's economic performance. Investing in international funds could also be rewarding when certain countries are doing better than Indian markets, and if your fund is invested in any of them. They offer another way to diversify your investment portfolio and a chance to own phenomenal stocks such as Microsoft, Google, Siemens and the like with a tidy sum.

The changing equation

On the face of it, international funds offer diversification. But is there enough merit in diversifying across countries? We ran two sets of numbers. If you look at the year-on-year returns of major stockmarket indices across the globe (see Global Market Performance), international funds make sense. For instance, in the sample of emerging and developed economies we have considered, Mexico topped the charts in 2004 and Brazil scored in 2005. Look at China's returns––while the Shanghai stockmarket outperformed the lot in 2006 and 2007, it was the worst performer in 2004, 2005 and 2008.

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How have the Schemes  fared

International funds invest either in foreign securities directly or through international schemes of their parent company

Returns as on 6 October 2009 Commodity-related funds are not included in the list
NA - Not available

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But those were annual returns. Typically though, you invest in equity funds with a long-term horizon. So, had you invested in the Indian markets as against any of the international markets five years back, and held on to your investments, you would not have regretted your move. Between 1 January 2004 and September 2009, the Sensex returned 19.71 per cent. Had you invested in Japan or, say, the Dow Jones of the US, you would have lost your money. Says Surajit Misra, national head, mutual fund, Bajaj Capital: "There should not be more than 15-20 per cent of international fund exposure in your portfolio, and it should be more focused on Asian markets. Also, the time horizon should be longer than for domestic funds, as only then it will serve the purpose of diversification."

Though the fall in 2008 was drastic globally, the recovery in some emerging markets, such as India, has been dramatic. So far in 2009, the Sensex has returned 68 per cent, followed by China (54 per cent). Market experts say the main reason for India's fast recovery is strong internal consumption and domestic demand, as against China's reliance on exports. On the contrary, the US and many countries in Europe are still reeling under unemployment. This also impacts consumption. Although the Indian economy received a big jolt in 2008, its resilience to the downturn relative to many global economies is well documented. Experts still feel that India is a favourite destination for foreign inflows on reasonable valuations and sound fundamentals.

What you should do

While conventional investment wisdom calls for diversification, investing in international funds goes beyond the principles of diversification. Once you pass the first level of diversification (investments within India) across sectors and scrips, either directly or through the mutual fund route, you come across a whole set of complicated factors, which either necessitates global diversification or does not. As a thumb rule, avoid country-specific funds as their fortunes depend on the movement of only a single country as also those that invest at least 65 per cent in Indian equities and the rest internationally. If you must go for international funds, go for those that invest their entire corpus internationally.

Avoid international funds if you are bullish on the long-term India growth story and feel enough of money is to be made in India. As Pune-based financial planner Veer Sardesai says: "Investing in international funds is more like owning an international brand car, when even an Indian car can serve the purpose."

The jury is still out on whether you should invest in international funds. Go for them, if you want a slice of the international pie.

kundan AT outlookindia DOT com