Emerging Market Investors Should Get Warning Label

It's curious to me how often I see asset allocation recommendations from brokerage houses suggesting investors increase their exposure to "emerging markets."  Let's take the case of India, which seems to have some advantages when compared to fellow BRIC Brazil, which is very sensitive to global commodity prices. India, by contrast, has a burgeoning domestic consumer sector which requires consumer products, retailing and financial services. This provides opportunities for domestic firms because of the restrictions placed on foreign firms looking to expand into Indian markets. 

In my mind, a U.S. investor has no reason to look at a significant portfolio exposure to Indian equities, because the potential returns aren't at all commensurate with the risks. The free fall of the Indian rupee leaves it 22% lower against the dollar than a year ago. Indian stock market indexes are down 11% in local currency terms for the three months, and about 18% in U.S.dollar terms according to the Journal.

The Journal says foreign investors put $9 billion into Indian equities in the first three months of 2012, and they are clearly trapped given the illiquidity in equity markets and the currency issues. Morningstar's highest rated fund for Asia ex-Japan is Matthews Pacific Tiger, which has 16% of assets in India, number two behind China in country allocation.  However, only one equity, Tata Power, is in the fund's top ten holdings. 

Morningstar analyst Patricia Oey says that five year Indian equity market volatility is 39%, measured as a standard deviation, which is higher than the S and P 500.  The currency market is probably a much more efficient predictor of future market performance than are the small, inefficient Indian equity exchanges.  A U.S. investor could, for the same or lower risk, probably make more money trading in small and micro cap stocks in the U.S., where the investor would have access to managements, Wall Street research, and managements more accustomed to the needs of equity investors. 

The Morningstar analyst says, "India also has an unfriendly business environment and widespread corruption."  This isn't news, but it's unusual to see it so plainly stated in a research piece.  Less well appreciated is the fact that Indian boards and managements are completely tone deaf to their responsibilities towards equity stakeholders, since many large companies are really family companies in public garb. 

The central government, which seems to be at sixes and sevens these days about its own agenda has recently gotten into a spat with the Italian government over the trial of Italian sailors accused of murder in India for a crime which may have been committed on an Italian ship in international waters.  The Italian envoy has been recalled, and the Italian government has expressed its "strong displeasure" with the Government of India.  On the face of it, this may not seem like much to an investor, but it's symptomatic of a central government which seems to take every opportunity it can to make India seem like an erratic, unpredictable, unsophisticated international wannabe rather than an emerging power on the international stage.  Investors should get a warning label with their mutual funds: "Investing in India Could Be Bad for Your Wealth."