NRI Corner

For a lot of US-based Non-Resident Indian (NRI) investors wanting to participate in the India story, Morgan Stanley India Investment Fund (MSIIF) ranks as an important investment destination. At least, a lot of Personalfn's NRI clients seem to think that way from the queries we have received on the fund and how it compares with Indian equity funds.

First the facts - MSIIF is close-ended ETF (exchange-traded fund). As the name indicates, the fund can be bought/sold over a stock exchange through a stock broker. ETF's are typically close-ended funds, so by being listed on a stock exchange liquidity is imparted to an otherwise illiquid investment. The other way to buy/sell funds is directly through the AMC (Asset Management Company), which is usually how open-ended funds work.

Since ETFs are traded on the exchange, they assume the characteristic of a listed stock/share in one very important aspect - pricing. Stocks trade at a price determined by the market. Stock markets determine the price of a stock based on several factors like company management, competitive strengths, profitability and overall economic environment. Even technical factors like demand and supply in a company's shares has an impact on the stock price. The stock price is almost always different from the "intrinsic value" of the share. If the stock market price is higher than the book value, a share is said to command a premium to its book value. If the stock price is lower than the book value, then it is said to be available at a discount to book value.

Like stocks, ETFs have a stock market price. Since ETFs are mutual funds, they also have an intrinsic value, more popularly referred to as NAV (net asset value). The NAV is calculated based on the value of its investments net of expenses (like fund management, sales and marketing). You might say that the NAV is the equivalent of the book value in the case of a stock. The ETF's price on the stock exchange is rarely the same as its NAV. ETF's usually trade at a price that is lower to the NAV, i.e. they trade at a discount to their NAV. When the ETF price is higher compared to the NAV it is said to be trading at a premium to NAV. Both the NAV and stock price of an ETF are widely disclosed so calculating the premium/discount is not very difficult.

When compared to open-ended mutual funds, ETFs are very different. Open-ended mutual funds have a relatively simpler valuation method. Since they are not bought and sold over the stock exchange, there is no dichotomy in terms of NAV and market price. There is just an NAV (a number that is widely disclosed) and investors can enter and exit the fund based on it (after adjusting for load if any). All purchases and sales are routed via the AMC or its Registrar.

Now that investors have a fair idea of how ETFs work vis-à-vis open-ended funds, we now pitch MSIIF against some of the best open-ended diversified equity funds (according to Personalfn's Research Team) in the Indian mutual fund industry. The main parameters over which we have evaluated performance of the funds are investment style, returns and expenses.

MSIIF is a close-ended, exchange-traded fund that seeks to achieve capital appreciations by investing primarily in equities of Indian companies. Since it invests predominantly (at least 65% of its assets) in companies listed in India, it is termed as a non-diversified fund. A diversified, overseas fund should ideally invest across the globe without any regional bias, when it assumes a regional/country bias, it gets classified as non-diversified.

MSIIF invests in Indian companies primarily through American, Global and other types of Depositary Receipts. In addition to these, it is mandated to invest in preference shares (preferred stock bond), convertible debentures, share purchase warrants and rights, equity interests in trusts and partnerships. It can also invest upto 25% of assets in unlisted Indian equities. As on June 30, 2006, the fund had a net asset base of US m.

Investment Style
In adherence to its investment mandate, MSIIF invests primarily in Indian companies with American Depositary Receipts (ADR) and Global Depositary Receipts (GDR). The number of Indian companies with GDRs offering (not more than 70 companies) and ADR offerings (12 Indian companies) is limited. So with less than 100 Indian companies to choose from, MSIIF's investment universe is quite restricted. On the flipside, MSIIF has the flexibility to invest upto 35% of net assets in companies outside India. This enables the fund to diversify its assets across companies in different countries/economies.

Indian equity funds can invest in domestic companies (listed as well as unlisted) without any restrictions, except those imposed on them by their offer documents. They can diversify across market capitalisations, which helps them benefit from growth potential of companies/sectors/themes a lot better than MSIIF, which has limited investment options at its disposal

However, MSIIF scores over Indian equity funds in terms of superior diversification across countries/economies. Indian equity funds are constrained by guidelines in this regard, although increasingly we are seeing domestic equity funds build provisions in their offer documents to invest in global markets. When domestic equity funds do start investing actively in global markets, it will put them at par with funds like MSIIF as far as global diversification is concerned.

Performance

Typical of ETFs, MSIIF has been trading at a discount to its NAV for most of its history. This changed quite dramatically when a surge in Indian equities over the past few years led to a turnaround in sentiment pushing MSIIF's share price into 'premium territory'. As on August 31, 2006, the fund's share price was at 2.2% premium to its NAV.

In order to evaluate MSIIF's performance objectively, we have short-listed some of the best diversified equity funds in the domestic segment. We have profiled these funds at length in some of the previous issues of the Money Simplified.

Since US-based NRIs cannot invest in schemes from certain AMCs like Franklin Templeton and HSBC Mutual Fund for instance, we have deliberately omitted equity funds from these AMCs in our analysis.

The results of the table are rather mixed, with neither Indian equity funds nor MSIIF emerging as clear favourites. Indian equity funds have performed decidedly better than MSIIF over 1-Yr; over 5-Yr, two Indian funds - DSP ML Opportunities (49.0% CAGR) and HDFC Top 200 (48.9% CAGR) have outperformed MSIIF (43.1% CAGR). Over the 3-Yr period, MSIIF (48.7% CAGR) outperforms two Indian funds - Sundaram Growth Fund (44.8% CAGR) and HDFC Top 200 (47.8% CAGR), but trails DSP ML Opportunities (49.8% CAGR)

It is noteworthy that the BSE Sensex, a leading large cap benchmark index of 30 companies, has outperformed all the funds in our sample, with the exception of HDFC Top 200, over 1-Yr. Over 3-Yr and 5-Yr however, all funds have got the better of the BSE Sensex.

It is apparent from the table that the one Indian fund that has outperformed MSIIF across time frames is DSP Merrill Lynch Opportunities Fund. Equally significant is its superior diversification across top 10 stocks (35.1% of net assets), the best of the lot. In terms of expenses (2.10%), the fund is way behind MSIIF (1.37%), but is still cheaper than both its Indian peers.

Diversification
MSIIF's portfolio is not as diversified as it should be. The top 10 stocks in its portfolio (as on July 2006) accounted for 49.1% of net assets, which is on the higher side. In our view, a diversified equity fund should have no more than 40% of assets in the top 10 stocks. Indian equity funds fare reasonably well on this parameter. All 3 funds in our sample have well-diversified portfolios, with only HDFC Top 200 (40.6%) being marginally off the mark.

Expenses
MSIIF's expenses (1.37% as on August 31, 2006) are considerably lower than those of Indian equity funds. However, investors must appreciate that the two categories are not strictly comparable since MSIIF is a close-ended ETF and does not incur the same kind of expenses (marketing, advertising, commission to agents) as an open-ended fund that is marketed through distributors/advisors.

Where NRIs must invest?
In our view, better-managed Indian equity funds have the potential (which is already reflected in their track records) to make NRI investors sit up and take notice. At the same time, MSIIF's steady performance, lower expenses and convenience in transacting (being exchange-traded) are factors that must be given due consideration by the NRI. We believe that in order to diversify their investments (beyond MSIIF) and ensure that they don't lose out on exciting growth opportunities presented by Indian equity funds, NRIs should work at building a portfolio that includes both open-ended Indian equity funds as well as MSIIF.

More from NRI Corner