What Return Can Investors In India ETFs Expect?

by: Shiv Kapoor

Over the long term the Indian markets represented by the Sensex can be expected to deliver an annualized return of 12.75%. This is a nominal return in Indian Rupees (Rs ) terms.

So what can a US Dollar (NYSEARCA:USD) investor in India expect as a long term return? What should an investor in (NASDAQ:INDY), (BATS:INDA), (NYSEARCA:EPI), (NYSEARCA:PIN), (NYSEARCA:SCIF), (NYSEARCA:SCIN), (NYSEARCA:INP), or (BATS:SMIN) expect?

Some of these ETFs focus on small and midcap stocks in India. Others focus on the large caps. Over the long term, large cap focused funds can look for nominal Rs returns similar to those seen on the Sensex. The small and midcap focused funds can look for a little something extra, but with far more risk and volatility.

A USD investor will find nominal Rs returns eaten away by four sources.

The first is US inflation, which reduces the real worth of the nominal return. Using history as a guide, you can expect 2% to 2.5% of investment returns to be surrendered to US inflation over the long term.

Secondly, you will surrender part of returns to fund expenses. You can expect these to average 0.90% to 1% for the above referred ETF's.

Thirdly, you will surrender part of the return to currency depreciation for the Rs is a currency in perpetual decay. You can expect to lose between 0.8% and 2.9% annually to currency depreciation over the long term.

Thus your long term real return expectation is likely to be between 6.35% and 9.05%, which compares with a long term real return of 6.5% in US.

And finally, there is that part of the return which you surrender to governments in taxes. I'll leave you to work that cost out since there is a wide range of outcomes depending on an individual's circumstances and behavior (trader versus investor).

Do bear in mind that the focus on return is over the long term. Over the short term, tail risks, black swans, the economic cycle, market timing and the risk aversion or market cycle are amongst several factors which can impact returns. Over the long term the standard deviation of returns is 5.5% and so you can be fairly sure that at different points in time over a ten year period your nominal Rs returns will wary between the long term nominal Rs return expectation of 12.75% plus or minus 5.5%. With the Sensex priced at near 21K, I believe it would not be unreasonable to expect real $ returns of between 7% and 9.2%. But of course crystallization of such a $ real return would depend on the outcome of several unknown future events.

Between 1991 and now, the Rs has depreciated at an annualized rate of 3.8% and the annualized depreciation rate since 2003 has been 2.3%. Why then estimate a long term annualized currency depreciation rate of 0.8% and 2.9%? In my view, the Rs is no doubt a currency in perpetual decay. However, it has depreciated more than it ought to have on account of abnormalities in the global financial markets and is now somewhat undervalued.

I don't believe US inflation, expense ratios or taxes warrants further discussion. However, the quantification of the expected annualized depreciation of the Rs does. I reproduce an extract from my book "A Hunt for Hidden Value: Sensex 50K, or India's Decade of Despair" to set out how I compute the annualized depreciation expectation for the Rs.

"The Rs as a Currency in Perpetual Decay

We know the price of the Rs. But to measure risk aversion, we first need to measure its value. First we need to recognize that the Rs is a currency in perpetual decay. After all the price of the Rs in $'s was Rs 26 in 1991 and Rs 48 in 2003. Today it is at over Rs 61. Why? As with most things it is about demand and supply.

The first cause is inflation differentials. If we accept that inflation is essentially a monetary phenomenon, we must accept that the inflation differential reflects the change in relative supply between the two currencies, where each currency is measured in worth with respect to the goods and services it can purchase in its domestic market. By looking at inflation differentials, we deal with the currency supply part of the equation.

The impact on exchange rates through changes in the trade balance gets reflected through the inflation channel. If money supply is sterilized, there is no impact on exchange rates. However, if money supply is not sterilized, the rise in money supply in one nation fuels inflation in that nation. And this is ultimately reflected in the exchange rate via the inflation channel. Thus a change in the trade balance does not in itself cause a movement in exchange rates. To examine the demand side of the equation, we must look to the cause of change in demand for a currency.

The primary cause for changes in demand for a currency results from changes in the competitive position between two nations. Put over-simply, if we have two widget makers & the one in US makes two widgets per hour, while the Indian makes one widget per hour, both with identical capital inputs, we could say that one unit of US Labor is equivalent to two units of Indian Labor. Now if after ten years we find that the Indian is making one and a half widgets per hour, while the US continues to produce two widgets per hour, again with identical capital inputs, we'd change the equation to one unit of US Labor being equivalent to one and a half units of Indian Labor. The competitive position has changed. Which brings up the question of what changes the competitive positions of two nations?

GDP growth comes primarily from rising capital & labor inputs & a little something else (the total factor productivity [TFP], which quantifies the effect on output not caused by labor & capital inputs. It's also known as the Solow Residual). TFP growth represents mainly incremental innovation, education, training and learning while doing. Empirical studies suggest it represents as much as 40-60% of GDP growth. When the TFP growth rate between two countries diverges, it creates an incremental competitive advantage for one at the expense of the other. And this influences exchange rates. In the short term, several factors can influence exchange rates. But in the very long term, it is inflation differentials and changes in TFP which matter.

Since 2003 the real GDP differential between US and India has been about 5.9%. Thus the TFP differential since 2003 is estimated at between 2.4% and 3.6%. With no inflation differential, the Rs would have appreciated at annualized rates of between 2.4% and 3.6% since 2003. The consumer price inflation differential between US and India has been about 5.3% since 2003. The WPI inflation differential between US and India has been about 4.3% since 2003. Thus, assuming no TFP differential, we should expect an annualized depreciation of the Rs of between 4.3% and 5.3% on account of inflation differentials. After considering both TFP and CPI differentials, an expectation of annualized rate of decay for the Rs of between 1.7% and 2.9% is not unreasonable. Considering TFP and WPI differentials, an expectation of annualized rate of decay for the Rs of between 0.8% and 2% is not unreasonable.

Given a value of Rs 48 in 2003, the value of the Rs today should vary between Rs 57.70 and Rs 65.50 based on TFP and CPI differentials. However, given the vastly different construct of the US and India CPI baskets, the TFP and WPI differentials might be more appropriate. The indicative value for the Rs based on TFP and WPI differentials is Rs 51.10 to Rs 58.50.

Something unlikely to occur in a hurry is the Rs at Rs 51 to Rs 52. These levels would be cause to examine our faces closely in the mirror while searching for a pronounced nervous twitch."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: While I have no long positions in the several ETF's mentioned in this post, I am long several stocks in the India large and mid-cap space. Several of these stocks are included in the portfolios of the ETF's mentioned in this post. This article contains extracts from my recent book Sensex 50k, or India's Decade of Despair which is available at the Kindle Store.