Question

Why is marking-to-market difficult for open-end mutual funds investing in international equities? What solution would you suggest?

Answer 1

Solution:

Why marking-to-market difficult for open-end mutual funds investing in international equities;

Marking to market refers to the daily settling of gains and losses due to changes in the market value of the security. For financial derivative instruments, such as futures contracts, use marking to market.

In accounting, marked to market refers to recording the value of an asset on the balance sheet at its current market value instead of its historical cost.

According to GAAP, record certain assets, such as marketable securities, at market value on the balance sheet because this value is more relevant than historical cost for this type of asset. Gains and losses from marketable securities are reported differently depending on whether the asset is classified as available-for-sale or trading.

Should you invest in international mutual funds:

• These funds offer the benefit of diversification, but consider the risks too
• Use these funds for some tactical allocation when there is a strong case for a particular market to do well

Topics

International Mutual Funds Investment in International Securities

What are they:

International funds invest primarily in securities of foreign companies listed in foreign markets. But they differ on structure, the markets they invest in and the type of asset class they take exposure to.

There are international funds that invest directly in international stocks, and others that invest in international indices such as the Nasdaq or the S&P 500. There are some that act as feeder funds which invest in an identified mutual fund in the international market. Then there are fund of funds that invest in units of international funds.

“From an investor’s perspective, whether the fund creates its own portfolio, which feeds into an investor here gets the opportunity to achieve currency and geographical diversification. There is no particular cost advantage in either structure. However, a feeder fund that invests in an ETF is likely to have lower costs.

The geographies or markets in which they invest is another basis for categorization. Some funds that focus on a single economy, while some others invest across geographies.

Themes are another way to categorize an international fund. Some invest in emerging markets, while others in commodities and so on.

Pros and cons

The principal advantage international funds offer is that of diversification.

Different economies and markets do not move in tandem with each other. International funds provide an opportunity to invest in the economy that is performing well at a particular point in time. The good returns from the foreign market will support the overall return from your portfolio in periods when the primary market, in this case the Indian market, is not doing well.

These funds also offer the benefit from diversifying into a different currency. Rupee depreciation enhances the returns from investments made in foreign markets.

But there are drawbacks as well. First, you would be unfamiliar with the economy and the market in which the fund invests. Not all international funds have performed well in the past one year. Funds invested primarily in the US markets did well, while those invested in, say, the Brazilian or Hong Kong markets did poorly. Selection of the right opportunity is, thus, important, but you, as a retail investor, may have limited availability of information and the skill to determine whether the economic and political conditions of a foreign market are suitable for investment.

Second, the currency factor can affect your returns. One of the reasons for the good return performance of international funds in the last one year has been rupee depreciation. The one-year return from such funds has been bolstered by the over 5% depreciation in the rupee against the US dollar in the same period. That may not have been the case if the rupee appreciated instead.

The tax aspect is the third drawback. International funds are taxed as debt funds, unless they invest at least 65% of their portfolios in Indian equity instruments. When treated as debt funds, short-term capital gains are taxed at the investor’s marginal rate of tax and long-term capital gains on investments held for more than 36 months is taxed at 20% with indexation benefits.

What you should do:

While the diversification argument is a compelling one, the risk-reduction benefit of a small allocation on the portfolio may be negligible. A larger allocation may not be advisable given the risks associated with an unfamiliar market and geopolitical and forex risks.

That leaves the case for returns. Use these funds for some tactical allocation that you can consider when there is a strong case for a particular economy or market to do well.

“Investors in India are under invested in Indian equities itself. Investing in other markets is for investors who understand the associated risks well,"

If we see these funds as products that retail investors can consider for diversification benefits as well as to hedge any future dollar expense, say, funding an education abroad. “An average retail investor is less likely to have the opportunity to diversify into international markets. These funds are a good way to get stocks of global e-commerce leaders and other technology companies that are a part of our daily lives into their portfolios. On a sustainable basis, having an SIP in a US fund is better than investing a lump sum”.

Hence: Like with all equity investments, have an adequately long investment horizon when investing in these funds.