Evaluating India ETFs: Three Important Factors To Consider

by on December 20, 2011 | Updated July 18, 2012 | ETFs Mentioned:

With year-end rebalancings underway and planning for 2012 ramping up, many investors are taking a look at asset classes that have struggled this year in hopes of identifying assets with significant long-term upside at discounted prices. One asset class that keeps turning up in the hunt for investment bargains is India, one of the world’s most exciting emerging markets that has struggled mightily throughout 2011.

India is expected to experience elevated growth rates for several decades to come, eventually becoming the second largest economy in the world. As the nation’s massive population continues to urbanize and acquire discretionary wealth for the first time, the country’s stock markets are poised to appreciate dramatically. Yet India ETFs turned in some of the most disappointing returns of 2011 due to concerns over inflationary pressures, outdated infrastructure, and a general wave of risk aversion. That has positioned the several ETFs that offer exposure to Indian stocks on the watch list of risk-tolerant investors willing to bet that the fortunes of this economy turn around in 2012 and that the tremendous economic potential is further unlocked in the new year.

For investors looking to bet on Indian stocks, there are eight different ETFs out there that tap into this market. While these funds have some general similarities, there are nuances to each can result in very different risk/return profiles. Below, we run through the factors to consider when evaluating potential India ETF investments:

Structure

Most of the exchange-traded products that offer access to Indian stocks are traditional ETFs that actually hold component stocks. There is, however, also an ETN option on the table; the iPath MSCI India Index ETN (INP) is a debt instrument whose performance is linked to an index consisting of about 70 large cap Indian stocks. Most investors are aware that there are some distinctions between ETFs and ETNs; the latter allows investors to avoid tracking error, but exposes them to the credit risk of the issuing institution.

Generally, tracking error is a relatively minor concern; most fund managers can replicate their target benchmark to within a few basis points. In this corner of the market, however, tracking error can be a significant concern because Indian stocks are not always the most liquid securities. Consider that for the year ended September 30, the PowerShares India Portfolio (PIN) was down about 27.3%, even though the underlying Indus India Index lost only 23.3% during the same period. That’s a 400 basis point differential, which can translate into a big dollar discrepancy on a large position. It’s the same situation with the WisdomTree India Earnings Fund (EPI); the returns to that ETF have lagged behind the underlying index over the last one year and three year periods.

The big tracking error in India ETFs makes a compelling argument for utilizing an exchange-traded note to tap into this asset class. There are, of course, some drawbacks to that route as well; beyond the credit risk component, the exposure offered by INP might be less desirable due to the top-heavy nature of the underlying index (the top ten names account for more than half of the total portfolio).

Small Caps vs. Large Caps

The most popular India ETFs are generally dominated by large cap Indian stocks, including Reliance Industries, Infosys, Tata Motors, and Oil & Natural Gas Corp. There is nothing necessarily wrong with that approach, as large cap-focused products allow investors to establish positions in the stocks that account for the bulk of an economy’s total market cap. But it should be noted that investing in large cap Indian stocks is not the same as investing in small cap Indian stocks, and the difference between the two can lead to big deltas in bottom line returns.

Large cap Indian stocks are more likely to generate portions of revenue and earnings fro overseas markets, whereas small cap stocks are generally more reliant upon domestic consumption patterns. That may put small cap stocks “closer to the ground” in India, positioning them to better capitalize on the demographic and economic trends now playing out in the Indian market.

Of course, small cap stocks are generally more volatile than their large cap counterparts, and that holds true in India as well. So small cap India ETFs were among the worst performers from the entire equity ETF universe in 2011, done in by the same characteristics that propelled them to big gains during the bull market of 2010.

Complete exposure to India requires both large cap and small cap stocks, making products such as SCIN and SCIF useful for rounding out a portfolio and tapping into Indian companies of all sizes.

Consumers Are Key

We believe that the most promising corner of the Indian stock market covers consumer goods and services. The investment thesis behind this view is quite simple; as the Indian middle class swells–it is expected to more than triple over the next 15 years–demand for consumer products of all types will surge. Spending on cars, electronics, and leisure activities in India will skyrocket over the next two decades, creating a tremendous opportunity for the companies that provide these goods and services. Simply put, the number of consumers in India is climbing quickly, and growth will only accelerate going forward.

So it’s important to note that the weightings afforded to the consumer sector can vary significantly among India ETFs:

  • India Earnings Fund (EPI): 13%
  • MSCI India Index ETN (INP): 12%
  • India Portfolio (PIN): 13%
  • S&P India Nifty Fifty Index Fund (INDY): 18%
  • India Small Cap Index ETF (SCIF): 31%
  • India Small Cap ETF (SCIN): 28%

As pointed out above, small cap ETFs tend to have a greater allocation to the consumer sector, further highlighting the potential benefits of diversifying exposure across companies of various sizes. It should also be noted that the India Consumer ETF (INCO) offers a pure play opportunity in this corner of the market for bulking up the weight to this important sector.

Bonus Factor To Consider: Commissions

Generally, it’s important to closely analyze the expenses of potential ETF investments–especially if you’re considering a long-term position. In the case of India ETFs, the expenses are generally similar, ranging from 0.78% for PIN to 0.89% for INCO, INDY, and INP. Only one India ETF, however, can be traded without commissions; the India Earnings Fund (EPI) is included on the commission free ETF trading platforms for both E*TRADE and TD Ameritrade.

The ability to trade commission free certainly shouldn’t be the only factor considered when selecting an ETF for exposure to Indian stock markets, but can certainly be an opportunity to maximize the cost efficiency of your portfolio.

Disclosure: No positions at time of writing