What NRIs should invest in

Ask any Non-Resident Indian about his mutual fund portfolio and there is very good chance that Morgan Stanley India Investment Fund (MSIIF), an exchange-traded fund (ETF), features in it. A lot of NRIs want to know if there is a better alternative to Morgan Stanley ETF in the domestic mutual fund segment.

Before we analyse whether MSIIF is a better bet against its counterparts in India, let us first understand some basic characteristics of ETFs. ETFs are close-ended funds that are bought and sold on the stock exchange.

So ETFs, despite being close-ended are liquid. Since ETFs are traded on the exchange, they assume the characteristic of a company stock/share in one very important aspect -- pricing.

Stocks trade at a price determined by the market. The price, in turn, is determined by several factors like company management, competitive strengths, profitability and overall economic environment. Even technical factors like demand and supply in a company's shares has an impact on the stock price.

The stock price is almost always different from the "value" of the share. If the stock market price is higher than the book value, a share is said to command a premium to its book value. If the stock price is lower than the book value, then its said to be available at a discount to book value.

Much like stocks, ETFs have a stock market price. Since an ETF is a mutual fund, it has an NAV (net asset value) as well, which is the value of its investments net of expenses (like fund management, sales and marketing). You might say that the NAV is the equivalent of the book value in the case of a company.

The ETF's price on the stock exchange is rarely the same as its NAV. ETF's usually trade at a price that is lower to the NAV, i.e. they trade at a discount to their NAV. When the ETF price is higher compared to the NAV it is said to be trading at a premium to NAV. Both the NAV and stock price of an ETF are widely disclosed so calculating the premium/discount is not very difficult.

Investors would have noticed how similar an ETF can be to a stock with regards to pricing. But when compared to open-ended mutual funds, ETFs are very different.

Open-ended mutual funds have a relatively simpler valuation method. Since they are not bought and sold over the stock exchange, there is no dichotomy in terms of NAV and market price. There is just an NAV (a number that is widely disclosed) and investors can enter and exit the fund based on it (after adjusting for load if any).

Having understood how ETFs work differently from open-ended mutual funds, it's now time to bring MSIIF under the scanner and compare it with some of the best open-ended diversified equity funds (according to Personalfn's research team) in the Indian mutual fund industry. The main parameters on which we have evaluated performance of the funds are investment style, returns and expenses.

First, a brief profile of MSIIF. MSIIF is a close-ended, exchange-traded fund that seeks to achieve capital appreciations by investing primarily in equities of Indian companies. It invests at least 65% of its assets in companies listed in India.

It invests in Indian companies primarily through American, Global and other types of depositary receipts. In addition to these, it is mandated to invest in preference shares (preferred stock bond), convertible debentures, share purchase warrants and rights, equity interests in trusts and partnerships.

It can also invest up to 25% of assets in unlisted Indian equities. As on June 30, 2005, the fund had a net asset base of $501 million.

Investment Style
In line with its investment mandate, MSIIF invests primarily in Indian companies with American Depositary Receipts (ADR) and Global Depositary Receipts (GDR). The number of Indian companies with GDRs offering (not more than 70 companies) and ADR offerings (12 Indian companies) is limited.

So with less than 100 Indian companies to choose from, MSIIF's investment universe is quite restricted. A positive with MSIIF is that it can invest upto 35% of net assets in companies outside India. This enables the fund to diversify its assets across companies in different countries/economies.

With Indian equity funds of course, its relatively simple. They can invest in Indian companies (listed as well as unlisted) without restrictions. They can diversify across market capitalisations, which helps them benefit from growth potential of companies/sectors/themes a lot better than MSIIF, which has limited investment options at its disposal.

As far as diversification across countries/economies are concerned, Indian equity funds are constrained by guidelines. But the wheels have been set in motion to grant Indian equity funds more freedom and flexibility to invest a portion of assets in companies listed outside India.

Undoubtedly this will help Indian equity funds with expertise in global equity research to diversify their assets across countries/economies. To that end, MSIIF and Indian equity funds will be at par (when guidelines are in place in the Indian context) as far as global diversification is concerned.

Performance

MSIIF: NAV Vs Share Price

Share Price NAV 1-year 33.7% 40.2% 3-year 61.5% 51.0% 5-year 33.8% 27.4% Incep. 11.6% 12.1% (Data as on December 2005)

Typical of ETFs, MSIIF has been trading at a discount to its NAV for most of its history. This changed quite dramatically when a surge in Indian equities over the past few months led to a turnaround in sentiment pushing MSIIF's share price into 'premium territory'. As on January 30, 2006, the fund's share price was at a 13.7% premium to its NAV.

To give investors an idea of what MSIIF has achieved compared to Indian equity funds, the Personalfn research team has short-listed some of the best diversified equity funds in the industry.

Since US-based NRIs cannot invest in schemes from certain AMCs like Franklin Templeton and HSBC Mutual Fund for instance, we have deliberately omitted equity funds from these AMCs in our analysis.

MSIIF Vs Indian equity funds

Fund Name	Nature	NAV (Rs)	Assets (Rs m)	Top 10 stocks	1-year	3-year	5-year	Exp. Ratio
DSP ML Equity Fund	Open	34.95	1,994	34.9%	79.4	78.4	31.0	2.39
HDFC Cap Builder G	Open	52.65	104,627	41.3%	43.2	77.7	37.1	2.08
HDFC Equity Fund G	Open	108.46	186,056	62.6%	58.5	77.0	44.1	2.00
HDFC Top 200 Fund G	Open	81.03	78,403	41.7%	50.3	75.8	42.0	2.20
Sundaram Growth Fund G	Open	48.90	10,506	31.6%	38.4	65.4	32.7	2.47
Morgan Stanley IIF	Closed	1,679.85	22,577	44.0%	33.7	61.5	33.8	1.41

The NAV appreciation of all funds has been calculated on a dollar-denominated

basis for ease of comparison.
MSIF's net assets as on June 30, 2005. The top 10 stocks are based on its September 30, 2005 portfolio.
MSIIF's performance details are based on its share price and not the NAV.
NAV and net assets data of MSIIF has been converted into Indian Rupees for ease of comparison
All NAV returns are on an annual compounded basis. All data on MSIIF sourced from www.etfconnect.com

As is apparent from the table, Indian equity funds have performed decidedly better than MSIIF over the 1-year and 3-year time frames. We have calculated NAV returns of all Indian schemes in US dollar terms to neutralise the US dollar effect in the case of Indian funds. Over the 5-year period, MSIIF (33.8% CAGR) outperforms two Indian funds - Sundaram Growth Fund (32.7% CAGR) and DSP ML Equity (31.0% CAGR) but trails all the three HDFC Mutual Fund schemes.

Given the blistering performance of Indian stock markets over the last couple of years, we believe that investors should probably not read too much in the shorter 1-year and 3-year performance of the funds in our sample.

Instead they should consider the longer 5-year time frame to evaluate if MSIIF makes the cut compared to its Indian peers. After having outperformed two of the funds in our sample over the 5-year period, we believe MSIIF's performance can be termed as above average.

In terms of portfolio diversification, MSIIF is reasonably well-diversified. The top 10 stocks in its portfolio (as on September 2005) accounted for 44.0% of net assets.

In our view, a diversified equity fund should have no more than 40% of assets in the top 10 stocks. Indian equity funds fare reasonably well on the 40% diversification parameter. Except for HDFC Equity Fund (62.6%), an aggressively managed fund, all Indian equity funds in our sample have either less than 40% in the top 10 stocks or marginally exceed that limit. So if you discount for HDFC Equity, Indian equity funds in our sample have diversified better than MSIIF.

Expenses
MSIIF's expenses (1.41% as on June 30, 2005) will appear low to the Indian equity fund investor who is used to seeing expenses in the 2.25%-2.50% range.

However, domestic investors must appreciate that the two categories are not really comparable since MSIIF is a close-ended ETF and does not incur the same kind of charges (marketing, advertising, commission to agents) as an open-ended fund that is marketed through distributors/advisors.

In our view, Indian equity funds have the performance and promise to warrant investments by NRI investors, even when they have more convenient options like MSIIF at their disposal. At the same time, MSIIF's good performance and lower expenses merit inclusion in the NRI's portfolio.

We believe that in order to diversify their investments (beyond MSIIF) and ensure that they don't lose out on exciting growth opportunities presented by Indian equity funds, NRIs should work at building a portfolio that includes both open-ended Indian equity funds as well as MSIIF.

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