The Indian stock market is notoriously volatile and investors considering any exposure to India should have a very high risk tolerance. Indian stocks (as measured by the MSCI India Index in US dollars) were among the best performing in the world in 2010, the worst performing in 2011, and were once again among the best in 2012.
This volatility can be partially explained by India's heavy dependence on foreign fund flows for investment and growth. When markets are in a "risk-off" mood, foreign funds quickly flow out of Indian equities, which tend to have low floats, and this stokes further volatility. In addition, foreign fund flows, combined with India's current account deficit, also drive volatility in the Indian rupee and, therefore, in Indian stock funds that do not hedge their foreign-currency exposure.
Catalysts for Growth
Despite being up 20%-plus on a year-to-date basis, the MSCI India Index is currently trading slightly below its average five-year trailing 12-month P/E ratio. Looking forward, we think there are a number of catalysts that may drive the market higher in the short and medium term.
At the beginning of December 2012, India’s Prime Minister Manmohan Singh received support from the parliament’s lower house for his plan to allow supermarkets with a foreign majority ownership to operate in India. This plan was first proposed in November 2011 but was retracted a few weeks later amid protests from opposition parties and small local retailers. Following this retraction, the Indian market tumbled through the remainder of 2011 on concerns that much-needed reforms to support economic growth and development would continue to face delays. The vote to support changes in foreign investment rules in supermarkets will hopefully build on a recent wave of reforms first announced in September 2012, which included small cuts in diesel subsidies and opening up airlines, electricity trading, and broadcast industries to foreign investment (though minority stakes). Areas next up for foreign investment approval include the pensions and insurance industries.
Another positive development is an improving outlook for energy firm Reliance Industries (RIGD), which is India’s largest private-sector firm and is often a significant holding in broad-market India exchange-traded funds (ETFs). This stock had been dogged by approval delays to drill more wells that were needed to offset declining gas output. India’s Oil Ministry has indicated that it will approve Reliance’s $6 billion exploration capital expenditure plan in one of its fields in the Bay of Bengal.
Risks Persist in India
A significant near-term risk is another stall in the reform agenda. Leading up to general elections in 2014, we could see politicians take a more populist stance, which could slow foreign investment liberalisation plans and potentially impede efforts to trim India’s fiscal deficit. Ongoing inflation also limits India’s central bank’s ability to implement a more growth-friendly, accommodative policy.
Over the longer term, there are other significant risks to India's growth story. Bewildering government red tape, poor infrastructure, widespread poverty, and low literacy rates will weigh on growth. The industrials sector, which accounts for about 20% of India's economy, remains burdened by highly restrictive labour laws, an 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, continues to be highly inefficient. Finally, we highlight that India imports about 70% of its domestic oil needs, which the government and the petroleum industry partially subsidise. A significant increase in the price of oil would weigh on India's public budgets and drive inflation.
Investing in India with ETFs
There are 7 India-focused equity ETFs listed on the Hong Kong and Singapore exchanges, most of which are tracking either the MSCI India Index or the S&P CNX NIFTY Index.
The MSCI India Index is a cap-weighted index that represents 85% of India’s total market capitalisation. It consists of 73 companies and is very top-heavy with about 50% of its total value comprised by the top ten constituents. The MSCI India Index also has a significant degree of sector concentration. Its three largest sector weightings are financials (29%), technology (15%) and energy (12%). ETFs tracking the MSCI India Index include: db x-trackers MSCI India TRN Index ETF (03045, LG8; listed in Hong Kong and Singapore; TER of 0.75%), iShares MSCI India Index ETF (I98, QK9; listed in Singapore; TER of 1.09%) and Lyxor ETF MSCI India (G1N; listed in Singapore; TER of 0.85%).
Consisting of only 50 stocks, the cap-weighted S&P CNX Nifty Index represents about 65% of the overall market capitalisation of India. The S&P CNX Nifty Index offers the same exposure to financials (29%) and energy (12%) as the MSCI India Index, but has a lower weighting in technology (12%). Also, given its smaller size, the S&P CNX Nifty Index is slightly more top heavy with the top ten holdings representing about 55% of the index’s value. ETFs tracking the S&P CNX Nifty Index include: db x-trackers S&P CNX NIFTY ETF (03015, HE0; listed in Hong kong and Singapore; TER of 0.85%), Lyxor ETF India (S&P CNX Nifty) (FC6; listed in Singapore; TER of 0.85%) and XIE Shares India (S&P CNX Nifty) ETF (03091; listed in Hong Kong; TER of 0.39%).
There is also the iShares BSE SENSEX India Index ETF (02836; listed in Hong Kong; TER of 1.15%) which tracks the BSE SENSEX index. The index consists of 30 stocks with the three largest sector weightings being financials (26%), oil & gas (14%) and fast-moving consumer goods (14%).
Finally, it is worth noting that most of India-focused ETFs available in Hong Kong and Singapore employ synthetic replication to track their indices; except the two iShares ETFs.
Gordon Rose, CIIA is an ETF analyst with Morningstar Europe.
Jackie Choy, CFA, Morningstar ETF Strategist, also contributed to this article.
