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By Patricia Oey

The Indian stock market is notoriously volatile, and investors considering any India exposure should have a very high risk tolerance. Indian stocks (as measured by the MSCI India Index in U.S. dollars) were among the best performing in the world in 2010, the worst performing in 2011, and are on track to once again be among the best in 2012. This volatility can be partially explained by India's heavy dependence on foreign fund flows for investment and growth. When markets are in a "risk-off" mood, foreign funds quickly flow out of Indian equities, which tend to have low floats, and this stokes further volatility. In addition, foreign fund flows, combined with India's current account deficit, also drive volatility in the Indian rupee and, therefore, in Indian stock funds that do not hedge their foreign-currency exposure.

Despite being up 20%-plus on a year-to-date basis, the MSCI India Index is currently trading slightly below its average five-year trailing 12-month P/E ratio. Looking forward, we think there are a number of catalysts that may drive the market higher in the short and medium term.

On Wednesday, India’s Prime Minister Manmohan Singh received support from the parliament’s lower house for his plan to allow supermarkets with a foreign majority ownership to operate in India. This plan was first proposed in November 2011 but was retracted a few weeks later amid protests from opposition parties and small local retailers. Following this retraction, the Indian market tumbled through the remainder of 2011 on concerns that much-needed reforms to support economic growth and development would continue to face delays. Wednesday’s vote to support changes in foreign investment rules in supermarkets will hopefully build on a recent wave of reforms first announced in September this year, which included small cuts in diesel subsidies and opening up airlines, electricity trading, and broadcast industries to foreign investment (though minority stakes). Areas next up for foreign investment approval include the pensions and insurance industries.

Another positive development is an improving outlook for energy firm Reliance Industries, which is India’s largest private-sector firm and is often a significant holding in broad-market India exchange-traded funds. This stock had been dogged by approval delays to drill more wells that were needed to offset declining gas output. India’s Oil Ministry has indicated that it will approve Reliance’s $6 billion exploration capital expenditure plan in one of its fields in the Bay of Bengal.

Risks
A significant near-term risk is another stall in the reform agenda. Leading up to general elections in 2014, we could see politicians take a more populist stance, which could slow foreign investment liberalization plans and potentially impede efforts to trim India’s fiscal deficit. Ongoing inflation also limits India’s central bank’s ability to implement a more growth-friendly, accommodative policy.

Over the longer term, there are other significant risks to India's growth story. Bewildering government red tape, poor infrastructure, widespread poverty, and low literacy rates will weigh on growth. The industrials sector, which accounts for about 20% of India's economy, remains burdened by highly restrictive labor laws, an unstable power infrastructure, and complicated tax rules. The agriculture sector, which accounts for about 20% of the economy but employs about 50% of the population, continues to be highly inefficient. Finally, we highlight that India imports about 70% of its domestic oil needs, which the government and the petroleum industry partially subsidize. A significant increase in the price of oil would weigh on India's public budgets and drive inflation.

The Funds
There are four India-focused equity ETFs that provide broad exposure to the Indian market. The broadest, largest, and most seasoned option is WisdomTree India Earnings (EPI) (expense ratio 0.83%). The fund, which tracks an earnings-weighted index, has had a risk/return profile very similar to the broad, cap-weighted MSCI India Index since its inception in late February 2008. However, the index underlying the WisdomTree fund has about 150 more constituents and, as such, offers greater small-cap exposure. This is evident in the average market cap of its portfolio, which is $8 billion, whereas the average market cap for the MSCI India Index is $14 billion. EPI's top sector weightings are financials (27%), energy (19%), and technology (12%). Like most foreign-equity ETFs, EPI does not hedge its foreign-currency exposure.

Other options include PowerShares India (PIN) (0.78% expense ratio), iShares S&P India Nifty 50 Index (INDY) (0.89%), and iShares MSCI India Index (INDA). These funds, including EPI, are highly correlated, but there is some return difference due to slightly different sector weightings. INDY has higher weightings in consumer names (20%) and less exposure to energy names (12%).

Matthews India (MINDX) (1.18%) is an actively managed open-end fund that has outperformed the MSCI India Index on an annualized basis over the past five years with slightly lower volatility. This fund is heavy in consumer (25%) and industrial (18%) names and has almost no exposure to energy names.

There are also two closed-end fund options-- India Fund (IFN) (1.33%) and Morgan Stanley India (IIF) (1.29%), both of which have been slightly less volatile than the MSCI India Index over the past five years. These funds also have an overweighting in consumer names and an underweighting in energy names.

Source: India Reforms Are Positive For Stocks: 4 ETFs, 2 CEFs And A Mutual Fund To Consider