New Paths Into India Offer Alternative Indexing Strategies
By Murray Coleman
Index Universe, NY
Wednesday, 06 February 2008
With stocks in India's major indexes compounding at an annualized rate topping more than 20% in the past decade, it's not surprising that the exchange-traded funds (ETFs) market focusing on that country is about to expand threefold.
But do long-term-minded investors really need so much of a still-emerging marketplace?
"People ask why they need more exposure to India," said Luciano Siracusano, research director at WisdomTree Investments. "The Indian economy is growing faster than the rest of the world. And it's an excellent diversifier for U.S.-stock focused portfolios."
But other broader emerging markets ETFs already offer exposure to India. For example, the Vanguard Emerging Markets ETF (AMEX: VWO) had about 8.3% of its holdings invested in that market heading into 2008.
India is becoming a bigger part of cap-weighted indexes, points out Siracusano and Ranga Nathan, managing director at Indus Advisors in Chicago. Both WisdomTree and PowerShares are racing to join an existing exchange-traded note (ETN) that focuses on India. The PowerShares ETF will follow an index developed by Indus.
Race Is On To Capture Country's Growth
The country's market cap size is trading around $1.1 trillion now. That would equate to about 2.5% of the world's total. By contrast, India's market cap represented some 0.2% of the world in 1989.
"So it has increased in size 12-fold," said Siracusano. "And most of that growth has come in the past five years."
The country's gross domestic product rose from being a fraction of the world's total to 6.3% in 2006. India's share is expected to keep rising and reach 6.6% in 2008.
Emerging markets has been the fastest-growing part of the equity markets worldwide not only in the past five years but also the past 10 years, says Siracusano.
"The question is whether you're comfortable with the weightings of India in the market-cap-weighted emerging markets ETFs out there," he added. "Some people want to make their own country allocations and this is an easy way to do it."
The WisdomTree Emerging Markets High-Yielding Equities ETF (NYSE: DEM) doesn't give India a large weighting since the country's tax policies tend to work against companies offering higher dividends, Siracusano says.
But emerging markets as a whole are paying roughly 10% of the global dividend stream, according to WisdomTree research. Although he doesn't give specific recommendations on asset allocation issues, Siracusano adds: "We think that 10% range is a good starting place for diversification purposes in emerging markets."
New Ways To Slice And Dice India
For those interested in juicing up their exposure more to India, later this month some definite alternatives should be available.
Currently on the market is the iPath MSCI India ETN (NYSE Arca: INP). But it uses offshore derivate instruments, or ODIs. The Indian government has clamped down on use of ODIs in recent months to slow the flow of "hot money" coming into the economy.
With regulators restricting trade in derivates contracts by outside investors, critics argue that the net result is that INP now isn't acting like an open-end vehicle. At one point late last year, the ETN's price was trading at around a 20% premium to its net asset value.
As a result, the iPaths ETN now acts more like a closed-end fund, says Theodore Feight, president of Creative Financial Design in Lansing, Mich.
But he doesn't necessarily see that as a bad development. "I see a lot of the emerging markets ETFs trading like closed-end funds," Feight said. "So the iPaths ETN for India isn't out of the ordinary."
He's using INP as more of a trading vehicle, however, in clients' portfolios. "We don't mean to use it that way, but our strategy is to protect on the downside and get as much on the upside as possible," Feight said. "That means we put strict stop-loss orders on each ETF. In the case of our more-volatile funds, that can cause them to act more like trading vehicles."
Feight warns that INP has averaged daily swings of 2-3% since his advisors started using it. That was in December of 2006, just after the ETN launched.
"We use three different ETFs to gain emerging markets exposure," Feight said. "We like to create our own separate emerging markets allocations for some clients rather than using a broader benchmark. It lets us control volatility to a greater extent."
He says the firm will keep INP as part of its longer-term allocation plan for more aggressive investors. "Over the next 10 years, we think that India along with several other key emerging markets will provide important diversification benefits for U.S. investors," Feight said. "That's where we see more of the world's profits coming from in the future."
He adds that he likes some of the concepts behind the new India-focused ETFs. But he plans to monitor issues such as tracking error and performance over time before making any concrete decisions. "I'd like to see even more choices become available in emerging markets," Feight said. "The more tools you have to control volatility and deal with changing diversification issues over time, the better."
How WisdomTree Compares
The soon-to-debut ETFs specializing in India figure to introduce several new wrinkles.
The benchmark for WisdomTree's India Earnings ETF won't use derivates. It also will be broader in scope with some 150 local companies included rather than INP's total of around 62. And unlike the ETN, which is strictly market-cap weighted, WisdomTree's version will use a fundamentally weighted methodology. Names will be ranked chiefly by profitability measures.
As such, sector weightings should be much different in some areas. INP, for example, has more than a quarter of its assets in financials. WisdomTree's benchmark holds about half that much. Conversely, energy is a much smaller part of the ETN's portfolio than that of the new one. WisdomTree's index holds about 25% in that sector. Tech exposure is about the same in each.
"India's one of the most expensive markets in the world right now," said Siracusano. "With our focus on profitability rather than market-cap sizes, we're going to be able to give people an opportunity to gain exposure to the Indian market at more reasonable prices."
He estimates that the trailing price-earnings ratio of the underlying index for the new ETF is trading around 40% lower than that of the soon-to-be rival ETN's benchmark. By WisdomTree's figures, their ETF is trading at around 15 times trailing PE multiples compared to current market-cap-weighted indexes' 25 times.
PowerShares Using Indus Benchmark
The PowerShares India-focused ETF will provide a third alternative indexing methodology. While it'll come with a traditional market-cap-sized weighting overlay, the PowerShares India Portfolio will adjust individual names according to foreign investment flows.
The government imposes an average limit of 24% on foreign holdings in the country. But with its sheer size, Indus Advisors' Nathan says that still leaves room for around $250 billion in outside capital to flow into markets.
"But some industries are restricted more than others," he said. "Many banks, for example, can only accept about 20% in foreign investments. Media outlets are restricted to about 10%."
Such regulation varies not only by sectors but in many cases by companies, Nathan says. Figuring those sorts of nuisances into an index is important to truly capturing proper exposure to Indian stocks, he added.
"We've built a passive index that takes into account foreign holding limits, company by company. It also includes how much of those limits have been used," said Nathan.
Allocations are based on IndusCap. That's a measure of the capitalization available for each company to foreign investors each day. It takes into account not only current foreign holdings but also so-called "locked-in" shares. Those are shares not available in secondary markets. These are typically owned by groups such as promoters and government agencies.
The benchmark includes 50 stocks with the highest IndusCap measures. It's rebalanced quarterly. Nathan says that he expects turnover to be more than other India benchmarks.
No company will represent more than 10% of the index's total assets. And no single name in the bottom half of the weightings will be more than 5% of the total index. The top 10 names accounted for nearly half of the index's total entering February.
Indus also breaks sectors into broader categories than most benchmarks. Those are: Energy (25%); Tech and Telecom (28%); Financials (14%); Industrials (16%) and Consumers (10%). The latter includes Health care. Another 7% is scattered among other smaller categories.
WisdomTree says foreign investment levels are among the fundamental factors its new benchmark for India will consider as well.
"The investible universe an index measures is critical in markets like India where there are very defined limits on how much foreigners can invest," Nathan said.
