“The only investors who shouldn’t diversify are those who are right 100% of the time.” – Sir John Templeton
Geographical diversification is the practice of distributing an investment portfolio across different geographical regions or countries or markets so as to reduce the overall risk in the portfolio and also to enhance portfolio returns by investing in specific countries or markets that are expected to perform well.
As with diversification in general, geographical diversification is based on the premise that financial markets in different markets of the world may not be highly correlated to each other. Cycles that drive factors such as interest rates, currencies, commodities and businesses in general seldom move in perfect tandem with each other across markets. So also, the impact of events in any one region that affect financial markets in that region can be reduced by spreading investments. Losses in one market may be neutralised by profits in another, and in general, reduce the overall volatility in the overall portfolio value.
Statistically speaking, correlation measures the relation between two markets / investments. A correlation of 1 means that the two move in perfect unison with each other; a correlation of -1 means that the two move in perfect unison in opposite directions; and a correlation of 0 means that the relationship between the two is completely random in nature.
The global financial meltdown of 2008-09 saw equity markets across the globe fall more or less in unison. Investors who were geographically diversified in equities saw losses everywhere, but while they were not necessarily harmed by their diversification, they did not benefit by it either.
The events of 2008-09 raised doubts about the validity of the concept of geographical diversification reducing overall portfolio risk. However, the analysis of historical data of various markets proves that its merits are still intact, and that 2008-09 was an exception, rather than the rule.
Geographical diversification is therefore primarily a risk management tool which, if used carefully, can help in both preservation and enhancement of wealth.
While asset allocation is normally associated with the distribution of an investment portfolio across various asset classes, the term can be extended to cover investments in the home market and foreign markets. One or more asset classes can be considered to include foreign investments.
The geography can be an important factor to be considered while diversifying. The choice can be very large, with a number of developed, emerging or frontier markets to choose from. Risks and returns can vary greatly amongst these.
The quantum would depend on the call taken by the investor as to which asset class, how much of that and where, and could vary greatly from one investor to another. In general, geographical diversification could be considered for 10%-30% of the overall portfolio value across asset classes.
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Will geographical diversification improve portfolio returns? Not always necessarily, especially for Indian investors. India, being the developing economy that it is, offers relatively higher returns in almost any asset class available for investment in India when compared to the same asset classes outside India. However, what it could do is to offer a degree of protection against the high volatility that is typically seen in developing markets and a proper asset allocation could offer a greater degree of stability to the portfolio.
It would not be right to assume that India will continue to offer relatively higher returns compared to other countries forever. Historical figures have shown that no single market / country within an asset class has consistently outperformed over a long period relative to its peers, and that there is no strategy or tool to predict which market will outperform in any given year. The chart below shows the returns given by equities over various geographies in the last 10 years. What is apparent is that no country has been able to maintain its ranking with any degree of consistency over long periods. Diversified exposure to a broad array of markets and asset classes takes the guesswork out of deciding when, where and how much to invest.
Calendar year-wise global market performance
Major additional risks
In addition to the normal risks associated with investing in the home market, investing in foreign markets brings on more or less the same set of risks associated with that country and some additional risks – one of the most relevant being that of currency risk i.e. the fluctuation between the value of the home currency and the investee currency. Currency exchange rates tend to be volatile, and could move in either direction depending on a host of economic factors that affect the home country, the foreign country where the investments are made and global factors that tend to affect many / all countries. The direction and extent of these movements could impact the portfolio value significantly, and any investor considering making overseas investments must take this factor into cognisance.
Having said this, currency risk for Indian investors investing abroad, especially in developed countries, is slightly lower because historically, the Indian Rupee has tended to depreciate over long periods vis-a-vis most other currencies. This is primarily because of the fact that India has had negative current account balances for a number of years now, and it does not look like the situation will reverse in the next few years.
Geographical diversification for Indian investors
At the most convenient level, Indian investors have a choice of several mutual fund schemes that feed into international funds. Known as ‘feeder funds’, these are fund-of-fund schemes where all the funds collected in India are converted and transferred into its master fund(s) that operate abroad. The master fund generally operates in a foreign currency and could be focused on a geography, sector or theme. For example, the Franklin India Feeder Franklin US Opportunities Fund is an Indian feeder funds that feeds into the Franklin US Opportunities Fund, which is a fund that invests in equity shares of US companies. There are other such feeder funds available that invest in geographies such as US, Europe, China or Brazil, themes such as agribusinesses or mining and commodities such as gold or energy.
There are also a few Exchange Traded Funds (ETFs) that follow foreign equity indices and are traded on Indian stock exchanges. For example, ETFs tracking the Hang Seng index and the Nasdaq 100 index are listed in India.
The Reserve Bank of India allows resident Indian resident individuals to open bank accounts outside India and to transfer upto US$ 250,000 per financial year outside India under its Liberalised Remittance Scheme (LRS). Funds transferred under LRS are eligible to be invested in overseas capital markets in equity shares, debt securities, mutual funds, ETFs, immovable property and objects of art, with very few restrictions.
Overseas investments, especially direct investments, could involve registration with tax authorities and payment of taxes on incomes / profits in the foreign country in accordance with the rules there. Indians now have to pay taxes on their global incomes in India also. While India has double-tax avoidance treaties with several countries, it may not always be possible to keep tax outflows at the same rates as prevalent in India, and could impact the Indian investor’s post-tax return on investments. For example, India does not impose any capital gains tax on equity shares bought on a stock exchange, held for over one year and sold on a stock exchange. It may not be the same in other countries.
In the case of feeder funds, a holding period of at least three years would be required for profits to be considered long term capital gains, and thus be eligible for capital gains tax at a lower rate.
It would therefore be essential to consult a tax expert before making any overseas investments.
Overseas markets offer a very wide range of products for investments, including many where equivalent or similar products are not available in India. Apart from a huge range of equity shares and bonds for direct investment, mutual funds and ETFs of innumerable types across asset classes are available for investment in a host of currencies.
Geographical diversification should be looked at both as a risk management tool and as a return enhancer, and some amount of this kind of diversification is necessary for most portfolios to reduce the overall risk and potentially improve returns.