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By Patricia Oey

Investors love a good reform story. Last year, major reforms in Japan and Mexico captured investors' attention. This year, stocks in India and Indonesia have rallied in anticipation that a more business-friendly, reform-minded leader will soon be elected.

Last week, the Bharatiya Janata Party won a large majority in India's lower house of parliament, and it is expected that Narendra Modi will be selected to serve as India's 14th prime minister. Modi is currently the leader of the state of Gujarat, which has recently seen strong growth thanks to Modi's policies, which fostered a more business-friendly regulatory environment and large investments in infrastructure. Modi's leadership record and the BJP's relatively large majority win, which should make it easier to push through difficult reforms, have helped drive a strong market rally. For the year to date, Indian stocks have risen 12% in local-currency terms (as measured by the MSCI India Index), but thanks to a strengthening Indian rupee, the MSCI India Index (in U.S.-dollar terms) has climbed 18%.

At this time, the MSCI India Index is trading at a forward price/earnings ratio of 15 times, which is in line with the index's 10-year average. While some optimism about India's future may be justified, corporate India continues to grapple with many challenges in the near term, including above-target inflation, a high cost of capital, weak infrastructure, restrictive and outdated labor laws, and slowing gross domestic product growth. Stronger corporate earnings growth as a result of anticipated reforms may take a few years to materialize.

A Fund for India Exposure
iShares MSCI India (BATS:INDA) tracks a cap-weighted index and can be used to achieve exposure to consumer- and investment-driven growth in India. It is appropriate for use as a satellite holding.

It is important to note that the Indian stock market is one of the more volatile among its emerging-markets peers. Indian equities, as measured by the MSCI India Index in U.S. dollars, have had a five-year annualized standard deviation of returns of 30%, which is more than double that of the S&P 500 over the same span. And like most funds that invest in foreign equities, this exchange-traded fund does not hedge its foreign-currency exposure, so its returns reflect both the change in value of the underlying assets as well as the change in the Indian rupee against the U.S. dollar.

There are many factors that drive the volatility of Indian equities. India has a heavy dependence on foreign fund flows for investment and growth. When markets are in a risk-off mode, or when investors become concerned about a potential stall in economic reforms or a deterioration in macroeconomic fundamentals, foreign funds quickly flow out of Indian equities, which tend to have low floats. These factors, combined with India's current account deficit, drive volatility in the Indian rupee and, therefore, the returns of this fund. India also has a notoriously unfriendly business environment and is plagued by widespread corruption.

Fundamental View
For much of the past two decades, India's annual economic growth rates were in the mid- to high single digits. Much of this growth was spurred by "big bang" economic liberalization, which began in 1991. These reforms included the opening up of foreign investment and trade, privatization, improved regulation, and capital-market reforms. Even during the 2008 global financial crisis, India was able to continue growing at around 6% because of the economy's lower exposure to exports (relative to other emerging-markets countries), stimulative fiscal and monetary policies, and stable growth in domestic consumption.

However, relative to China, India's growth has lagged for a number of reasons, including significantly lower levels of foreign direct investment and very poor infrastructure, in part because of India's legendary red tape. In the second half of 2012, the Indian government approved of a new law that would allow foreign companies to hold a 51% stake in multibrand retailers. But additional rules, such as local sourcing requirements and large commitments for infrastructure spending, and the potential for an additional layer of state-level regulations resulted in very low interest by global retailers. To date, only U.K.'s Tesco has made a commitment to enter the Indian market.

Many hope the new leadership will usher in another series of major liberalization efforts that will unlock India's growth potential. But there continues to be many obstacles to India's growth. Bewildering government bureaucracy, poor infrastructure, widespread poverty, and low literacy rates will weigh on growth. The industrials sector, which accounts for about 20% of India's economy, is burdened by highly restrictive labor laws, 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, is highly inefficient. Also, 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 current account deficit and drive inflation. Finally, job growth continues to be weak, which is a significant economic and social problem, especially given India's relatively young population.

Portfolio Construction
This fund tracks the MSCI India Index, which is a free float-adjusted market-capitalization-weighted index designed to measure the performance of equity securities of companies whose market capitalization represent the top 85% of companies in the Indian securities market. The fund employs full replication to track its index.

Fees
This fund's expense ratio is 0.67%, making it the cheapest fund for exposure to Indian companies. During the past year, the fund's net asset value performance has trailed that of its index by 48 basis points per year, which is lower than the expense ratio. This indicates that the fund is tracking its index efficiently.

Alternatives
WisdomTree India Earnings (NYSEARCA:EPI) is the largest and most liquid U.S.-listed India ETF, perhaps because it is the oldest. It has more mid-cap exposure relative to other India ETFs. This ETF carries an annual expense ratio of 0.83%.

Matthews India (MINDX) (1.18%) is an actively managed open-end fund that carries a Morningstar Analyst Rating of Silver. This fund has heavy exposure to consumer (30%) and industrial (18%) names but does not own any energy stocks.

Those comfortable with the closed-end fund structure might consider India Fund (NYSE:IFN) (1.33%) and Morgan Stanley India (NYSE:IIF) (1.29%), which carry ratings of Bronze and Neutral, respectively. Each fund has a long track record of 20 years.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: Optimism In India