By Gaurav Sinha
There is little doubt in my mind that India is currently my favorite pick in emerging markets (EMs) for investors aiming for strategic growth. Driven by global "risk-on" and a host of local factors that I have covered in depth, the Indian equity markets have been doing very well for the last few months.
A more interesting question is this: What kind of exposure makes sense to allocate in the Indian equity landscape? The answer might be surprisingly simple for this large and fairly complicated economy: Stick to investing in fundamentals.
Let's take a dive into two common approaches to accessing Indian stock markets: WisdomTree's earnings-weighted "smart-beta" approach versus the MSCI market cap approach.
WisdomTree Earnings Methodology Racing Ahead Of Cap Weighting
The chart below compares the performance of the WisdomTree India Earnings Index (WTIND) with that of the MSCI India Index (MXIN) over the last year - a period in which Indian markets performed well alongside the rest of EM. With total returns of 30.69%, the WisdomTree India Index outperformed the MSCI India Index by well over 800 basis points (bps). That is, simply put, massive!
Indian Equity Vs. Emerging Markets Last 1 Year, 03/15/2016-03/15/2017
Reasons For Outperformance
The next question arises - what is driving this outperformance by WisdomTree's India Index? The answer has two parts:
A. Methodology - Sector Allocation & Stock Selection
The first clue to this outperformance lies in WisdomTree's sector over/under-weight and then its selection of companies within those sectors.
The left chart below shows WTIND's relative overweight in traditional sectors like Energy and Financials and its underweight in the Consumer and Health Care sectors. The right chart shows how these sector bets helped or hurt the WisdomTree Index. The right chart is an attribution breaking down total outperformance (blue bar) into sector bets (red bars) and stock bets (green bar).
It is evident: Most of the outperformance comes from the Energy and Financial sectors - the top two relative overweights in WTIND. What is even more interesting is if we break this total attribution (blue) into sector bet (red) versus stock bet (green), it becomes pretty obvious - not only did sector bets (i.e., overweight to Energy/Financials and underweight to Health Care) help, but stock bets within those sectors were the key drivers of overall outperformance by WTIND Index.
B. Investing 101 - Invest in Profitable Companies And Be A Frugal Buyer
At a higher level, these sector and stock selections are driven by WTIND's methodology, which selects only profitable companies and then weights them by their profits, or net income, to be precise.
Thus, an immediate outcome of this index methodology is that it more fundamentally emphasizes profits. In comparison, the MSCI India Index, which follows a market cap-weighted indexing process, selects and weights companies simply by their market cap size. Because WTIND weights by profits, the more profitable a company is, the greater its weight in the Index.
Finally, a disciplined approach implemented through an annual rebalance ensures a consistent applicability of this screen. Thus, if a company no longer remains profitable or its profits dwindle, no matter its size, it will be kicked out or reduced in weight.
The table below compares average price-to-earnings (P/E) ratio earnings per share (EPS) of the top three relative sectors' over and underweights in WTIND, as of March 15, 2017. It is very clear that WisdomTree's methodology and its disciplined implementation ensured overweights in sectors that had lower valuations.
Simply put: WisdomTree's methodology focuses on buying less expensive and more profitable portions of the market.
It is pretty clear that Indian markets have been doing well for some time, and EM investors could have potential upside by investing in India.
However, I believe that, in order to maximize profits, investors need to go back to basics and stick to the fundamentals of investing, which is what smart beta methodologies in general, and the WisdomTree India earnings approach in this instance, offer.
Important Risks Related to this Article
Investments in emerging, offshore or frontier markets are generally less liquid and less efficient than investments in developed markets and are subject to additional risks, such as risks of adverse governmental regulation and intervention or political developments.
Investments focused in India increase the impact of events and developments associated with the region, which can adversely affect performance.
Gaurav Sinha, Asset Allocation Strategist
Gaurav Sinha is currently working as Asset Allocation Strategist at WisdomTree since November 2014. He is leading the Portfolio Analytics and Solutions team and builds specialized investment solutions along with customized analytics for our clients. He is also deeply involved in advancing WisdomTree's product suite, and has particular expertise on India. Gaurav came to WisdomTree after stints at World Bank, Morgan Stanley and recently with Windhaven Investment Management. He received his Masters in Financial Engineering from Columbia University in 2009 and holds a bachelors Engineering degree from the prestigious Indian Institute Of Technology (IIT).