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Pursue the Explosive Indian Stock Market With Care

A look at the funds that invest in 2012's hottest market.

William Samuel Rocco, 03/06/2012

The Indian stock market has shone in 2012 amid notable improvements in the U.S. economy, moderate progress on Europe's challenges, and other positive developments around the world. The MSCI India Index has gained 27% in U.S. dollar terms for the year to date through Feb. 29, in fact, as macroeconomic conditions have gotten better there and the rupee has strengthened versus the U.S. dollar. That return compares quite favorably to those of other stock markets in the developing world as well as to those of equity exchanges in general: The MSCI Emerging Markets Index has returned 18%, and the MSCI All Country World Index has returned 11% in U.S dollar terms thus far in 2012.

This year certainly isn't the first time in the 2000s that Indian stocks have thrived during rallies. Indeed, the MSCI India Index posted an 85% annualized gain as stocks surged around the world from March 2009 through December 2010, while the MSCI Emerging Markets Index earned a 65% annualized return and the MSCI All Country World Index earned a 46% annualized return during that time span. India stocks also posted terrific absolute gains and topnotch relative returns in the early 2003 to late 2007 global stock rally. As a result, the Indian market has been one of the best places in the world to invest over the past decade, with an 18% annualized return over the period.

Evidently, fund companies have been impressed by the upside potential of the Indian market. They've launched six new open-end India-stock funds since the end of 2010, more than doubling the number of such funds to 11. Along a group of India-focused ETFs, that was enough for them to have their own Morningstar category, and we will be launching an India-stock category this spring.

But the impressive gains by the Indian market and the growth in the number of funds dedicated to that country does not mean that investors should rush out and buy an Indian stock offering. There are several reasons investors should think twice before purchasing such funds, in fact, beginning with their risks.

Packed With Peril
Single-country emerging-markets funds tend to be quite risky for two reasons: Most of them have investment universes that are pretty concentrated, both sectorwise as well as being confined to a singular geography; and nearly all developing nations face a plethora of macroeconomic and political challenges. Both are true for India-stock funds. Financials and technology stocks combine to make up roughly 45% of India's total market capitalization. Meanwhile, high inflation is a recurring issue in India, and governmental corruption, excessive bureaucracy, inadequate infrastructure, and budgetary shortfalls are persistent problems there. These risks translate into extreme volatility over time and exceptional losses in tough times. Indeed, the one India-stock fund that has been around since the early 2000s has a 10-year standard deviation of 32--in line with that of the MSCI India Index--while the average diversified emerging-markets fund has a 10-year standard deviation of 24 and the typical world-stock offering has a 10-year standard deviation of 18. In 2011, when equities fell around the world and inflation and some of India's perennial problems worsened, the average India-stock fund plummeted 36%. That plunge was nearly double the 20% decline of the average diversified emerging-markets fund and several times the 8% drop of the typical world-stock offering.

Generally Pricey
Investors who are considering India-stock funds have other issues to ponder as well. For starters, these funds tend to be quite expensive. The average front-load fund has an expense ratio of 1.94%, which is quite high in absolute terms and 19 basis points higher than the median for front-load emerging-markets offerings. And while Matthews India MINDX has an attractive expense ratio of 1.18%, the other no-load option, Wasatch Emerging India WAINX charges 1.95%.

Mainly Unproved or Unimpressive
What's more, nearly all of the India-stock funds are unknown quantities or uninspiring performers at this point. Six of them have been around for just six to 13 months and thus are far too young to have meaningful records. There are three India-stock funds that are between three and four years old, but two of them have posted disappointing returns (the third has earned solid though not spectacular results thus far). And Eaton Vance Greater India ETGIX has lagged the MSCI India Index by significant amounts over the trailing three-year, five-year, and 10-year periods.

Matthews India is the notable exception. It has handily outpaced the index and all its peers that existed over the trailing three years and the trailing five years. And it has suffered rather average volatility--for an Indian-stock offering--along the way. Meanwhile, Matthews India is in the hands of a seasoned and skilled management team; the team employs a sound growth strategy that has earned strong long-term results at other single-country funds from Matthews; and the firm is a topnotch Asia boutique that has delivered the goods across its lineup. All this, plus the relatively low costs, provide ample grounds to believe that this fund can continue to produce superior results.

William Samuel Rocco is a senior fund analyst with Morningstar. He would like to hear from you, but he cannot provide individual-portfolio or financial-planning advice.

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