Corruption Scandal Sinks India ETFs

by on November 22, 2010 | ETFs Mentioned:

The past few weeks have seen a surge in activity coming from international markets; most of it, unfortunately, negative for equities. China hinted at raising their rates to control inflation while Ireland remains close to both a bailout and a default on its debt, potentially sinking the euro zone in the process. Friday brought another hit from overseas, as a major corruption scandal broke in India sinking stock markets in the nation. India has quickly become one of the world’s most popular emerging markets, and is poised to grow at an exponential rate over the next few decades. As such, many investors have allocated their assets to the booming nation, believing that it will provide the high growth that is difficult to find in developed nations. But being an emerging market comes with its fair share of risks, and last week’s scandal certainly reminded investors of this often-forgotten fact. [see also Playing The Emerging Markets Through Small Cap ETFs].

This corruption scandal was centered around one of the major telecommunication firms in the country, Reliance Communications. The company is accused of selling licenses well below market rates to politically connected companies over a year ago and are estimated to amount to an astonishing $40 billion. Though it would seem like this issue should have been solved long ago– especially considering that the country’s Prime Minister, Manmohan Singh had well over a year to investigate these fraudulent claims– it is in fact still an open case that has put the nation’s leaders who had been at the heart of the recent economic liberalization plan under fire [see also How Investors CAN Play The BRIC Through A Different Set Of Country ETFs].

While the Prime Minister was not implicated in the scandal, it has already begun to take its toll on his cabinet. Several days before the scandal broke, telecommunications minister A. Raja voluntarily stepped down from his position, though he maintains that he has done nothing wrong. This was the third departure that Singh’s party has seen in the last month, prompting a backlash from the Congress Party. “Our economy may be increasingly dynamic, but our moral universe seems to be shrinking” said Sonia Gandhi, president of the Congress Party.

India’s telecommunications market provides service for nearly 700 million people, the second largest in the world behind China. “The country’s telecommunications regulator said Thursday that 69 of the 130 telecommunications licenses issued since 2006 should be revoked” writes Heather Timmons. Though this would be a serious undertaking, the interim minister of telecommunications says that he will not take any actions that would disrupt the service of current customers, but he did imply that a number of operations may be forced to pay more for the licenses that were obtained at an illegal premium, suggesting that large fees may be coming to a host of companies in the near future [see also India ETFs: Five Ways To Play].

The timing of the news is especially unfortunate, as it weighs on an economy that has been booming so far in 2010 with a projected annual growth rate of 8.5%. It also comes right after U.S. President Barack Obama visited the nation to help strengthen economic ties and push for India’s inclusion on the UN Security council as a permanent member. This massive scandal could potentially deal a great blow to this plan as it shows that India may not have come as far as many people might think. While their economy is steadily growing, its efforts to maintain solid levels of growth that benefit everyone in the country have been consistently pinned down by crime and corruption. Since 1948, corruption issues have cost India roughly $462 billion according to an anti-corruption group in Washington. If India wants to continue to maintain its status as one of the top destinations for investor capital, it must first first clean up its act or risk falling behind other, better run emerging nations. “This is a very serious crisis of credibility” for the Indian government, said Mahesh Rangarajan, a political analyst and history professor at Delhi University. “When you are deregulating an economy, you can’t do away with regulation.” [see also Emerging Market ETFs: Seven Factors Every Investor Should Consider].

India’s stock exchanges took a major hit in trading Friday, with the Sensex closing 1.7% in response to the news while the National Stock Exchange’s Nifty Index finished down 1.8%. As Indian exchanges had a rough day, so did various ETFs that allocate their assets to the nation, especially those that focus on small-cap companies in the country. Below we outline three ETFs hit hard by the scandal and that investors should keep an eye on should further issues pop-up in the corruption-riddled nation [see all the ETFs that offer exposure to India with our free Country Exposure Tool].

WisdomTree India Earnings Fund (EPI)

EPI seeks to replicate the performance of the WisdomTree India Earnings Index, which is a fundamentally weighted index that measures the performance of companies incorporated and traded in India. This fund offers an exposure to many large-cap firms of the nation, with its top ten holdings featuring State Bank of India, and the in-focus Reliance Communications. The fund has heavy weightings in the financial and energy sectors, par for the course as far as large cap emerging market funds are concerned [see all of EPI's holdings here]. Though the fund has surged roughly 17% on the year, it has endured losses nearing 7% last week, with 2% of that figure coming on Friday [see also TD Ameritrade To Offer Commission-Free ETF Trading].

India Small-Cap Index ETF (SCIF)

This ETF offers exposure to small cap firms domiciled in India, which many feel, is a more accurate representation of the local economy, as many large cap funds allocate to big firms that have multinational operations. SCIF allocates the majority of its assets to the industrial materials sector with financials accounting for the second highest weighting. SCIF is only a few months old, but has generated returns of 8%. But as the scandal broke out this past week, the ETF lost over 10% in just five days, with a third of those heavy losses coming on Friday alone.

India Small Cap ETF (SCIN)

For investors seeking another option to play the Indian small-cap market, SCIN offers a compelling choice. While SCIN focuses its holdings on financials and IT services, it spreads its assets relatively evenly across a wide range of market sectors, with no single segment receiving a weight above 15%. SCIN has been around a bit longer than SCIF, but the fund is still well under a year old. Thus far in 2010, it has paid out 10.5%. But this past week saw the ETF lose 10.6% with 3% of that hitting home on Friday.

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Disclosure: Photo courtesy of Jochen Westermann. No positions at time of writing.