The bullish trend in Indian equities has made our portfolios look good. At the same time, many investors are feeling worried by the sky-high valuations and rising inflation which could lead to tightening of liquidity. One way to mitigate the looming risk is by diversifying your portfolio with a global exposure. Indians have progressively increased their usage of global products and services in the past few decades, widening their choices and deriving better value for money. However, this inclination has not spread to investments – global stocks account for merely 0.4% of the total AUM of Indian mutual funds. It is high time that the average Indian investor included global stocks in his portfolio. Here’s what one should keep in mind when investing in foreign securities.No longer a fad, but necessary diversificationTill some time ago, a global equity exposure was considered a fad that only deep-pocketed high-net-worth investors could indulge in. That’s no longer true. “Every investor should have some proportion of his stocks portfolio in foreign equity. The investing logic is unbeatable and the exchange rate provides an additional cushion,” says Dhirendra Kumar, CEO of Value Research. In the current scenario, where one cannot rule out the possibility of a prolonged slowdown in the domestic market, it makes sense to hedge the portfolio by investing some portion in foreign markets that have strong growth prospects.Geographical diversification helpsThere is significant variance in 3- and 5-year returns of US and Indian markets. UK markets have lagged due to Brexit. 85323399Focus on qualityUS tech companies have gained more than Indian tech stocks. 85323406Though in the short term the returns from foreign markets are no different from those of domestic equities, there is substantial variance in the medium- and long-term returns. Investing in these markets could create real diversification.More importantly, cross-border investments are also a means to industry diversification. Increasingly, key industries are dominated by a few countries. A stark example is the concentration of high-end IT companies in the US such as Apple, Alphabet and Microsoft. The US companies have captured a large share of the value of recent IT developments, when compared with countries like India which are lower down in the IT value chain. If you do not have an exposure to US equities, your portfolio will not have adequate exposure to the high-end IT sector.Incidentally, US stocks can be bought in fractional units. So even if you don’t have a large sum to invest, you can start buying fractions of the shares on offer.Foreign debt not as attractive as equitiesWhen it comes to foreign markets, investing in debt instruments is not very lucrative. Most advisers would recommend investing in developed markets because investing in less developed countries could add significant country risk. But developed countries have high per capita GDPs, limited need to invest in infrastructure and their currencies serve as international reserve currencies. All this results in capital surpluses and, consequently, in very low real interest rates (see graphic).Indian debt is more lucrativeBond yields in India are significantly higher than in US. 85323471Though a depreciating rupee would enhance the returns of foreign debt securities, this benefit may not fully compensate for the negative interest differentials between India and the developed markets. Also, investment in foreign debt requires reliable local advice on debt markets and funds. Since few Indian investors have such access, that too would add to risk.Mind the impact of forexA foreign exposure is even more necessary for investors who anticipate future expenses in foreign currency (for example, child’s fees at a foreign university). For such investors, the India-only portfolio represents unhedged risk to a declining rupee. In fact, in such cases, the diversification of the portfolio into dollar-denominated assets is simply a hedge rather than an exposure.Strengthening forex adds to returnsBut this cuts both ways. A stronger rupee will erode the returns. 85323549The foreign exchange impact on global investments cuts both ways. If the rupee strengthens against a currency, it will pare your returns. While the dollar has declined marginally against the rupee in the past one year, the pound has risen 5%. However, the forex movement will mostly work in favour of Indian investors.Focus only on top marketsWhen selecting a destination for your investments, focus on the top end of the market. Invest only in the countries with the most developed economies and the deepest markets. The US is the obvious first choice – it is, by far, the largest and deepest market. Market regulation is solid and legal systems provide strong protection against malpractice. Its ecosystem supports innovation which translates into more successful companies. The USD remains the main global reserve currency and, consequently, when the liquidity cycle reverses, the impact on the US is likely to be less severe. UK could be next – it has many of the attributes of the US (regulation, legal systems, innovation), however, the impact of Brexit is still to fully unravel. Germany and Japan could also be possible candidates. Avoid emerging markets – they could pose several additional risks. In some cases (like China), the quality of information is poor and disclosure standards are questionable. “China is an extremely risky bet, given the way the Chinese government controls the economy,” says Viraj Nanda, CEO, Globalise. Others (like Russia) are not true market economies and government intervention can create unanticipated losses. Still others (like Turkey) have tenuous balance of payment situations and their currencies pose unacceptable risks to investors.Avoid direct equities; buy ETFs or mutual fundsThis is true for almost all small and retail investors. Don’t take the direct equity route but benefit from the fund manager’s knowledge by investing in mutual funds or in ETFs. “When in doubt, and when lacking in information, begin by choosing the less adventurous option,” advises Dhirendra Kumar of Value Research. In mutual funds, this implies passive, index-based funds rather than actively managed funds. Data shows that managers of actively managed funds in the US are struggling to outperform benchmark indices. Most US investors have started moving from actively managed funds to ETFs. By mid-2020, around 48% of all investment in US equity mutual funds was through ETFs.The NSE and the BSE have announced that Indian investors will soon be able to purchase global stocks on their platforms. While NSE will offer select US stocks, BSE plans to go beyond the US and offer stocks of other countries as well.Actively managed global fundsThese funds have outperformed the frontline index and broader market. 85323631A simpler route is investing in global funds offered by fund houses in India. Operationally, this is the simplest option because you don’t need to open a bank account, trading account or demat account in a foreign country. Nor is there the problem of repatriating funds from abroad or the tax compliances of holding foreign assets. Many fund houses in India offer schemes that give you a global exposure. Some of these are actively managed, while others are fund of funds or ETFs. One can invest in these funds without having to open a trading account with a foreign brokerage house.Mind the tax complianceMake sure you comply with the tax rules relating to foreign assets. When you invest in global funds managed by fund houses in India, you are only taxed for the gains. Merely investing in these funds does not require any tax compliance. But when you invest in foreign stocks through a brokerage house based abroad, you are required to declare these foreign assets in your tax returns.Also Read: How foreign investments are taxed in IndiaDecide your exposure levelHow much should you invest in global securities? There is no airtight formula to determine what portion of the equity portfolio should be allocated to foreign stocks. This decision is too complex and personal to be subject to universal rules. Intuitively, one should have at least 10% and at most 40% of one’s equity portfolio in foreign stocks. It’s always best to start small and, as you get more knowledgeable, increase exposure. Best of luck.(The writer is a former banker and now works as a financial consultant)

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