Unlock India's Massive Potential With ETFs

By Ryan Barnes | April 09, 2008 AAA

Two new ETFs hit the exchanges in the past few months with a tight focus on India. They are welcome additions to a very short list of investment options for foreigners looking to invest in domestic Indian stocks.

The Wisdom Tree India Earnings ETF (NYSE:EPI) debuted in late February, followed by the PowerShares India Portfolio ETF (NYSE:PIN) in March. Both give investors access to large Indian corporations, many of which do not have shares cross-listed on foreign exchanges, while offering the core ETF advantages of intraday trading and low expense ratios. (To read more on how to take full advantage of these vehicles, see How To Use ETFs In Your Portfolio.)

A Quick Primer on India
The Indian economy is one of the five largest in the world and more importantly, it's one of the fastest-growing, having cranked out GDP growth of over 8.5% annualized over the past five years. That's close to the tantalizing returns offered by China over the same time period (10.6%), but without many of the geopolitical concerns.

India is also home to the second largest population of any country on the planet, and may even be on pace to surpass China someday because there no restrictions about the number of children citizens can have. Although the country is embracing the ideals of both democracy and capitalism, India is still trying to get through what in could be considered the "teenage years".

India still needs massive investments in infrastructure such as the electric grid, roadways, and banking. But the majority of the population has access to basic commodities as well as education, and the country is a world player in several large industries, including information technology, banking, chemicals and pharmaceuticals. This has helped India's middle class grow to over 300 million people, larger than the United States and the Eurozone.

Limited Options for Indian Investment
Before the two ETFs began trading, there were just a handful of mutual funds that invested solely in Indian stocks, and even fewer big-name ADRs on the American exchanges. One of the biggest reasons is due to heavy restrictions by the Reserve Bank of India (RBI) limiting outside investment in domestic companies. Like in China, most of the large corporations in India are wholly or partially run by government, such as the State Bank of India and Oil & Natural Gas Corp. Ltd.

Different Benchmarks, Similar Holdings
Even though the two ETFs have different benchmarks, the top holdings and sector weightings are rather similar, a sign of the relative youth of the Indian economy. Reliance Industries, for example, is India's largest private company, and makes up about 10% of the Powershares offering and over 15% of the WisdomTree ETF. All in all, six of the top 10 holdings are the same for the two funds, and the sector weightings both echo high allocations toward energy (above 25% for both) and information technology (above 10% in each).

The main index on the Bombay Stock Exchange is known as the Sensex, and represents 30 of the largest companies. But neither fund models this index directly, instead choosing proprietary indexes in part to help get around all the company ownership restrictions.

• The WisdomTree fund uses a fundamentally-weighted index (a company-wide philosophy) which takes into account such fundamental metrics as net earnings and revenue; the index currently has over 120 companies and includes some mid-cap and small-cap companies.

• PowerShares uses the Indus India Index, which is comprised of 50 companies selected from a master list of 400 of the country's largest domestic equities.

Because of the different benchmarks and general ownership restrictions, it should be noted that both ETFs will likely have pretty large tracking errors to the Sensex and even each other. (Not all funds match the index returns. Find out how to avoid costly surprises in Don't Judge An Index Fund By Its Cover.)

Recent Activity in Indian Markets
The 30-member Sensex is down about 20% this year after scorching its way through 2007 with returns greater than 40%. Looking at the chart of the index, it is clear that there was some overbuying late last year, so some of the drop this year can be attributed to technical considerations. The bigger threat is rising inflation in the country, coupled with slowing GDP growth. Because of the inflation threat, the RBI doesn't have as much leeway to spur growth through monetary actions, so the slow growth will have to work its way through.

On the bright side, India is more dependent on internal growth than China, so the Indian economy might be more insulated to economic weakness in the U.S. Also, any attempts made by the RBI to deregulate markets will only encourage larger and larger pools of investment dollars. Just a few months ago mega asset manager BlackRock (NYSE:BLK) announced it was buying out Merrill Lynch's (NYSE:MER) 40% stake in its India-based investment group to aid its entry into the market.

Parting Thoughts
Because of the higher risks and volatility, investors should look to only invest a small portion of their equity allocations into any foreign market, in the range of 5-10% max. But the secular trends for India's growth remain intact, and investors would be wise to educate themselves on the world's second largest country, and keep abreast of news regarding new investment options in the country.

For more information on using ETFs to diversify your portfolio geographically, check out our articles Finding Fortune In Foreign-Stock ETFs and Go International With Foreign Index Funds.

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