The case for a standalone India allocation - Foresight - Schroders
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Foresight The case for a standalone
India allocation
March 2022
Marketing material for professional investors only
CONTENTS
INT RODU CT ION 3 3. T
HE BENEFITS OF AN ADDITIONAL
I N D I A A L LO CAT I O N
An allocation to India can 16
increase diversification
1. T
H E S TAT E O F I N D I A’ S
G R OW T H S TO RY
Alpha opportunity, especially 16
in the small-cap segment
India’s demographic dividend 5
A passive approach has not delivered 18
The emergence of India’s new 7
in India
digital economy
2. T
H E K E Y C H A R AC T E R I S T I C S
O F I N D I A’ S S TO C K M A R K E T
A large and liquid opportunity set 9
Smaller stocks have outperformed 11
in India
Rising retail trading activity 12
International investors’ exposure 13
to India
Improving sustainability reporting 15
by Indian companies
INTRODUCTION
The case for a standalone India allocation
In this paper, we argue that India offers an opportunity for investors because of its
unique characteristics.
On the macroeconomic side, India is on the course to become the most populous
country in the world by the end of this decade. Its relatively young population and low
urbanisation rate have the potential to spur economic growth for decades.
The emergence of India’s new digital economy is opening up opportunities in sectors that
are enjoying growth rates far above the growth rate of the broader economy.
For international investors, a number of attributes set India apart from its global peers.
First and foremost, India has a large and liquid stock market, spread across the market
cap range, that is well suited for an active strategy.
Indian stocks can also improve diversification in global equity portfolios, given their lower
correlation to global equities, a reflection of a more domestically oriented economy.
Taking account these benefits, we argue that investors should consider a satellite
allocation to India, in addition to a broad emerging markets strategy. Such an allocation
would better capture the opportunity in India.
Over the last decade, one of the most significant In 2021, the announcement on the clampdown on
developments in global equity markets has been the fast-growing technology and education sectors rattled
rise of China’s onshore stock market, also know as some high profile Chinese stocks. In addition, issues in
A shares. China’s real estate sector and adherence to a zero-Covid
strategy have weighed on the broader stock market.
The appearance of A shares in global equity portfolios
has coincided with the rise of China’s economic power, Consequently, investors might be wondering if there
significant increase in domestic consumption, and the are any other emerging markets (EM) with the same
proliferation of the digital economy. Owning stocks calibre of opportunity that could also help to increase
tied to these key themes has allowed investors to diversification within their portfolios.
benefit from China’s growth story.
We believe that India, while unique, does share some
As we look ahead, the case for a standalone China A key similarities with China, both in terms of economic
shares allocation remains solid, as we first wrote in development and market structure, which warrant a
2019. However, China’s investment landscape has also closer look.
faced some turbulence in recent times.
Kristjan Mee
Strategist, Strategic
Research Unit
The case for a standalone India allocation 3
T H E S TAT E O F I N D I A’ S G R OW T H S TO RY
1. The state of India’s growth story
When talking about India, most people are aware that it is the second most populous
country in the world with a population of almost 1.4 billion people. Furthermore, the
UN projects that India will overtake China and become the most populous country
before the end of this decade.
India’s economic heft, on the other hand, has not quite
kept up with its growing population. This is evident in
India’s lack of progress in economic convergence, as we
wrote in 2021.
Even though India’s GDP per capita relative to the US
has double since the 1990s, it remains less than 5%
(Figure 1). This means that India has not been able to
follow the footsteps of it Asian neighbours of Japan,
South Korea and China.
In short, India’s economic convergence has been
relatively slow because of a number deficiencies that
have hampered progress. For example:
– Domestic savings are too low
– Public investment is insufficient
– The female labour participation rate is too low
– The share of informal workers is high
– Issues with power accessibility and dependence
on coal in power generation
Without resolving these issues, India is unlikely to follow
the classical, export heavy convergence model that has
propelled growth in current and former EM countries.
Moreover, it is not clear if this path is even available in
the current global economic environment.
Figure 1: India’s economic convergence has been limited
GDP per capita as % of US
60% 180%
160%
50%
140%
40% 120%
100%
30%
80%
20% 60%
40%
10%
20%
0% 0%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020
India China Korea Japan (rhs)
Source: Schroders, World Bank. Data as at 31 December 2020.
The case for a standalone India allocation 4
T H E S TAT E O F I N D I A’ S G R OW T H S TO RY
Figure 2: Public investment is set to increase sharply in India
Central government capital expenditure
(Rs bn) (%)
8,000 4.0
7,000 3.5
6,000 3.0
5,000 2.5
4,000 2.0
3,000 1.5
2,000 1.0
1,000 0.5
0 0
FY16 FY17 FY18 FY19 FY20 FY21 FY22 FY23
Capital expenditure Central govt. capex (as % of GDP)
Forecasts should not be relied upon and are not guaranteed.
Source: Ministry of Finance, Jefferies. Data as at February 2022.
That being said, India is not alone in having an Better roads and ports would go long way in improving
imperfect economic structure for convergence. Japan, India’s economic competitiveness, whereas ramp up of
Korea and China all had issues before they began solar panel production would help with the transition
their rise. from coal to sustainable sources of energy.
Furthermore, the latest developments indicate that India’s demographic dividend
India’s government is taking the right steps to resolve
at least some these issues, as it intends to significantly It remains to be seen how successful the government’s
boost public investment. Lack of investment, especially efforts will be in boosting India’s growth. But
in infrastructure, has been one of the most significant regardless of the outcome, India has a powerful
hindrances of India’s economic development. demographic trend on its side.
According to the latest annual budget, India’s central Historically, one of the underpinnings of successful
government’s capital expenditures are set to more convergence stories has been a significant expansion
than double by 2023 (Figure 2), relative to 2020 levels. of the labour force, driven by shifts in the population
The targets are ambitious, as the budget plan includes structure (Figure 3). For example, the share of China’s
25,000 kilometres of new highways, 100 new cargo working age population rose by almost 20 percentage
terminals and significant subsidies for solar panel points between 1980 and 2010.
manufacturers.
Figure 3: India has favourable demographics
Working age population as a share of total population
75%
70%
65%
60%
55%
50%
1980 1990 2000 2010 2020 2030 2040 2050
India China Korea Japan
Forecasts should not be relied upon and are not guaranteed.
The case for a standalone India allocation 5
Source: Oxford Economics. Actual data to 31 December 2020, forecast thereafter.
The steady supply of new workers is one of the factors
that can allow economies to maintain a persistently
high growth rate. The economic potential arising from
favourable shifts in the population structure is often
referred as a demographic dividend.
However, working age populations are now in
retreat in many of these countries, owing to low
birth-rates and ageing populations. China’s working
age population peaked in 2010 and is now in a firm
decline over the coming decades. This means that
demographics have turned from tailwind to headwind.
In India, by contrast, the share of working age
population is still rising because of the relatively high
birth-rate and the young population. According to
the latest estimates, India’s working age population is
projected to peak in the 2030s and fall only slightly from
there. Hence, India’s economy could sustain a period of
elevated growth, as the supply of labour rises.
One caveat here is that India’s low labour force
participation rate, especially for women, currently
prevents it from fully benefitting from favourable
demographics. So to fully reap the benefits, India
needs more people to join the labour force.
India’s demographic situation has some similarities to
its urbanisation trends. While India’s urbanisation rate
has increased over time, it remains very low at only
35%. In fact, India has the lowest urbanisation rate of
all of the major EM countries (Figure 4).
While the urbanisation process does not come
without issues, especially regrading the environment,
it can facilitate significant growth in investment as
well as consumption.
Figure 4: India’s urbanisation rate has potential to catch up
Urban population as a percentage of total population
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
India
Pakistan
Egypt
Philippines
Thailand
Indonesia
Poland
China
South Africa
Greece
Mexico
Korea
Colombia
Saudi Arabia
Brazil
UAE
Chile
Argentina
Qatar
Hungary
Czech Republic
Russia
Turkey
Malaysia
Peru
Source: Schroders, World Bank. Data as at 31 December 2020.
The case for a standalone India allocation 6
Why has India made so little progress with In a country where access to toilets was a major issue
urbanisation? Lack of investment, as highlighted until recently, the widespread adoption of mobile
above, is at least partially a cause here. The poor services has been a remarkable force of change.
quality of roads and the general lack of supporting Today, there are over 1.1 billion mobile subscribers in
infrastructure has simply held back urbanisation. India, which is over 90% of the population1.
However, should investment in infrastructure increase, Furthermore, internet and smart phone penetration has
as is currently planned, urbanisation could gain increased rapidly in the last few years, and half of the
momentum and give rise to demand for various of population now has internet access (Figure 5).
goods and services in India.
A key driver of this growth has been the fact that India
The emergence of India’s new has one of the lowest data costs in the world. For
digital economy example, the cost of 1GB of mobile data is 14 times
cheaper than in the UK, and 80 times cheaper than
When discussing India’s growth prospects, it is in the US2. It is perhaps not surprising that the use of
important to emphasise that the connection between digital services has blossomed.
economic growth, companies’ earnings growth, and
ultimately, equity returns, is far from straightforward. India’s favourable demographic mix and openness
to foreign capital have also made it a major strategic
Because of that, even in a moderate growth location for many technology companies. Global
environment, there can still be pockets of rapid giants like Meta (Facebook), Apple, Alphabet (Google),
growth. In India, one such example has been the Amazon, Netflix, Walmart, Tencent and Alibaba have
emergence of the new digital economy. made significant investments across key sectors of
India’s digital economy.
Figure 5: Rapid growth in internet and smartphone usage
Internet penetration (% population) India’s smartphone penetration (% population)
100 40
90
35
80
30
70
25
60
50 20
40 15
30
10
20
5
10
0 0
2015 2016 2017 2018 2019 2020 2014 2015 2016 2017 2018 2019 2020
India China US
Source: Statista. Data as at 31 December 2020.
1
Source: Statista. Data as at 31 December 2021.
2
Source: Motilal Oswl, Axis AMX, Data as at 15 November 2020.
The case for a standalone India allocation 7
T H E S TAT E O F I N D I A’ S G R OW T H S TO RY
As a result of this rapid adoption of digital Aside from the growth rates, the sizes of these sectors
technologies, new Indian technology companies highlight the effect India’s vast population can have on
have burst onto the scene, while large incumbent demand. For example, the e-commerce retail sector is
companies have changed their business strategies. forecasted to top $300 billion in 2030.
This shift is reflected in the surge of capital raised
by Indian companies, with 2021 breaking previous India’s private equity (PE) and venture capital (VC)
records, both in terms of primary, initial public sectors have also been growing at a rapid pace.
offerings (IPOs), and secondary issuance. The rise in activity is clearly visible in the number of
“unicorns” (Figure 7), which are defined as start-up
Crucially, some of the recent IPOs are new economy companies with a value in excess of $1 billion.
business models which were previously not listed in
India, or do not have many similar listed competitors. In 2021 alone, 44 start-up companies achieved the
unicorn status. This is more than in the previous ten
The food discovery and delivery company, Zomato; years combined. The pace has continued in early 2022,
online vehicle dealership company Cartrade Tech; as already ten companies have crossed the elusive $1
infrastructure investment units from PowerGrid and billion milestone in the first two months of the year.
environmentally friendly chemical producer Clean
Sciences and Technology, are all examples of the For investors, the shift to the new digital economy
changing landscape of the Indian markets. could offer attractive return opportunities, regardless
of the broader economic performance.
Looking ahead, India’s digital economy is forecast to
continue to grow at a rapid pace over the next decade. Nonetheless, as the experience of the US and China
Figure 6 shows that sectors such as e-commerce and technology sectors has taught investors, benefitting
online food delivery are projected to grow at more from growth is not always straightforward. That is why
than 20% annually, far above the growth rate of the we believe the key in searching for opportunities is
broader economy. to maintain an active approach, and to be selective in
order to avoid overpaying for companies.
Figure 6: Forecasted growth in India’s new digital economy sectors
Parameter Market in 2020 Market in 2030 CAGR* 2020-30E
Ecommerce Retail # Gross Merchandise Value ($bn) 35 314 23%
Online Food Delivery # Gross Merchandise Value ($bn) 4.3 40.0 25%
E-Commerce Logistcs # Market Size ($bn) 2.1 15.4 22%
Shared Mobility: # Gross Booking ($bn) 3-4 8-10 8-10%
Online Gaming # Market Size (Mobile Gaming) ($bn) 0.9 9.2 10%
*Compound annual growth rate.
Forecasts should not be relied upon and are not guaranteed.
Source: Bernstein Research. Data as at 31 December 2020.
Figure 7: Explosion in the number of “unicorns”
Number of new Indian start-up companies with a value over $1 billion
50
45 44
40
35
30
25
20
15
9 10 10
10 8
5 4
1 1 1 1 2
0
0
2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022
YTD
Source: Venture Intelligence. Data as at 28 February 2022.
The case for a standalone India allocation 8
T H E K E Y C H A RAC T E R I S T I C S O F I N D I A’ S S TO C K M A R K E T
2. The key characteristics of India’s
stock market
India’s progress in moving towards GDP levels of developed countries has been
underwhelming, as we demonstrated above. However, this economic track record is not
reflected in the performance of India’s stock market.
Figure 8 shows that across four time frames, the MSCI India Index has outperformed both
the MSCI China Index and the MSCI Emerging Market Index, delivering a return of 14%
annualised since 2002. This, again, highlights that stock market performance does not
have to be tethered to the economy.
In this chapter, we explain what has enabled India’s stock market to deliver these returns
and what makes India unique among its global peers.
Figure 8: India has outperformed China and broader emerging markets
Annualised total return in USD
18
16
14
12
10
8
6
4
2
0
3 years 5 years 10 years 20 years
India China EM
Past performance is not a guide to future performance and may not be repeated
Source: Schroders, Refinitiv Datastream. Data as at 31 December 2021.
A large and liquid opportunity set First, looking at market ownership, around 50% of
It may come as a surprise to some readers that India NSE shares are owned by private “promoters” and the
has a large domestic stock market. In fact, India’s two government (Figure 9, left chart). Private promoters
main stock exchanges, the National Stock Exchange are people who were instrumental at the time of
(NSE) and the Bombay Stock Exchange (BSE) are the establishing a company, for example the founders
9th and 10th largest stock exchanges in the world. of a company and those who are in control of the
company through majority shareholdings and/or their
Furthermore, there are more than 5,000 stocks listed management position.
on the BSE. Granted, not all BSE listed stocks are
actively traded, and liquidity is not always the best. That leaves a free-float of around 50%, of which
foreign institutional investors (FII) are by far the
The NSE, on the other hand, has fewer listed largest category at 43% (Figure 9, right chart). Their
companies at just over 2,000, but much better liquidity. ownership has been relatively stable since 2013. The
Hence, we will focus our analysis on the NSE. In high share of FIIs again highlights India’s openness to
addition to the sheer number of listed stocks, there are foreign investment.
several other aspects that make India unique.
The case for a standalone India allocation 9
Figure 9: Ownership of NSE listed stocks Figure 10: A wide selection of stocks listed on the NSE
Aggregate
Market cap range Number of stocks
>$25bn 28
$10–25bn 41
Large cap 69
$10–5bn 71
$2–5bn 135
Mid cap 206
Private promoters Financial institutions $0.50–2bn 295
Government Retail
DMFs Others $0.30–0.50bn 146
FIIs
Small cap 441
Free-float adjusted Source: Schroders, Refinitiv Datastream. Data as at 31 December 2021.
Clearly, there is a wide selection of stocks available
across the market cap spectrum. But how liquid are
these stocks? Figure 11 (overleaf) shows the key liquidity
metrics of NSE-listed stocks. A few points stand out:
– In a country where most business are family owned
and controlled, the average free float is upwards
of 40%, even for mid and small-caps. This is an
indicator of good market liquidity
– The ratio of the average daily traded value to the
total free float for small and mid-caps is much
higher than the same ratio for large caps. This
signifies higher trading activity for the relatively
smaller stocks
DMFs Non-promoter corporate – Nonetheless, sizing of positions in a portfolio is
FIIs Retail extremely important, as selling smaller stocks might
Financial institutions Other non-inst. non-promoters be costly and difficult
Other inst. non-promoters Non-promoter govt.
Source: NSE. Data as at September 2021.
As a comparison, foreign ownership is significantly
lower in China at less than 10% of free-float, despite
significant efforts to improve the accessibly of China’s
stock market to foreign investors.
What percentage of the 2,000 stocks listed on the NSE
are large and liquid enough to warrant being on the
radar of institutional investors?
Figure 10 shows that 716 NSE stocks have a market
cap of at least $300 million. Out of these 716 stocks, 69
have a market cap of more than $10 billion, classifying
them as large-cap stocks. Next, in the mid cap range
($2 to $10 billion market cap), there are 206 stocks.
Finally, in the small-cap segment ($300 million to $2
billion market cap) there are 441 stocks.
The case for a standalone India allocation 10T H E K E Y C H A RAC T E R I S T I C S O F I N D I A’ S S TO C K M A R K E T
Figure 11: Liquidity characteristics of Indian stocks
Large caps Mid caps Small caps
Av. Daily Traded Value 6 mths (US$mn) 54.3 20.3 12.3
Average Free Float (%) 52% 43% 46%
Total Free Float (US$bn) 1224 242 121
Total Market Cap (US$bn) 2381 552 283
Average FII Holding 22% 13% 12%
Large Cap: 1st -100th company in terms of full market capitalisation, Mid Cap: 101st -250th company in terms of full market capitalisation,
Small Cap: 251st company onwards in terms of full market capitalisation
Source: Axis AMC, Elara, Bloomberg, BSE. Data as on 30 June 2021, Values in US dollars.
The wide selection of stocks and sufficient market Smaller stocks have outperformed
liquidity mean that there are opportunities in in India
all market cap segments in India. This is what In India, smaller stocks have outperformed larger ones
differentiates India from many smaller emerging by more than 70% over the last two decades (Figure
markets that have a much more constrained stock 13, overleaf); even if the performance has ebbed and
universe, often limited to just a few stocks. flowed over the years.
However, while there are a wide selection of stocks in In 2014-2018, smaller stocks strongly outperformed
every market cap segment, the overall market cap is larger ones, as strong economic growth benefitted
still heavily dominated by a relatively small group of smaller companies relatively more. But as growth
large-cap stocks. In fact, the 30 largest stocks in the started to cool in 2018, the performance of small-caps
Nifty 500 Index3 make up half of the index’s market faltered as well.
cap, leaving 470 stocks to account for the remaining
50% (Figure 12). More recently, small caps have significantly
outperformed through the Covid-19 pandemic. This
Furthermore, the five largest stocks alone are 21% is because smaller companies have been more agile
of the index. This concentrated nature of the index in navigating the pandemic, and have benefitted
means that the market is sensitive to the performance from various pandemic fiscal measures. Furthermore,
of few large stocks, often at the expense of stocks in smaller companies have had no shortage of capital,
the mid and small-cap segments. And historically, it allowing them grow at a fast pace.
has been costly for investors to ignore smaller stocks.
There is a continuing debate as to whether smaller
3
Nifty 500 Index represents about 96% of the free float market
stocks should outperform larger ones over the long
capitalization of the stocks listed on NSE. term. In India at least, it has paid to own these stocks,
contrary to developed markets where smaller stocks
have underperformed their larger peers since 2005.
Figure 12: The Nifty 500 Index market cap is dominated by a few large stocks
Percentage of market cap
Five largest stocks 6 – 30 largest stocks Remaining 470 stocks
Source: Schroders, Refinitiv Datastream. Data as at 31 December 2021.
The case for a standalone India allocation 11T H E K E Y C H A RAC T E R I S T I C S O F I N D I A’ S S TO C K M A R K E T
Figure 13: Smaller stocks have outperformed larger ones in India
MSCI India Small Cap Index / MSCI India Index (total return, rebased to 100)
220
200
180
160
140
120
100
80
2002 2004 2006 2008 2010 2012 2014 2016 2018 2020
Past performance is not a guide to future performance and may not be repeated
Source: Refinitiv Datastream, MSCI, Data as at 31 December 2021.
Rising retail trading activity
An interesting recent phenomenon in India has been
the rapid increase in retail trading activity – similar
to that seen in various other global developed and
emerging markets. Figure 14 (overleaf) shows that new
NSE investor account openings have quadrupled since
2019 to 16 million, reflecting substantial retail inflows
to Indian equities.
Even though retail investors own only 19% of the free
float shares (see Figure 9), they account for more than
40% of NSE trading volume (Figure 15). This indicates
that retail investors are trading much more actively
than institutional investors.
The proliferation of retail trading activity has parallels
with China A shares, where at times, retail trading
activity has accounted for up to 80% of the total
market volume. And as we have written the past,
this activity has enabled active A shares managers to
deliver high and consistent alpha.
As retail investors often have shorter time horizons,
and can overreact to near-term news flow, this
can result in stocks being significantly under or
overvalued. Hence retail investor dominance provides
significant opportunities for more sophisticated
investors with rigorous investment processes and
longer investment horizon.
While it is still too early for a final conclusion, greater
retail trading activity could be a boon for active
management in India as well.
The case for a standalone India allocation 12T H E K E Y C H A RAC T E R I S T I C S O F I N D I A’ S S TO C K M A R K E T
Figure 14: New investor account additions on the NSE
Millions
16
14
12
10
8
6
4
2
0
FY11 FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19 FY20 FY21 H1 FY22
Source: NSE. Data as at September 2021.
Figure 15: Investor category’s share in NSE’s cash market turnover
100%
4 4 6 7 7.2 6.3 6.9
90%
21 17
18
80% 22 22.7 25.1 27
70%
60% 33 36
39
50% 39 38.8
45 43.2
40%
30% 23 21
16
15 15.3
20%
10 11 11.5 11
10
10% 11 10.7
7.5 8.3
10 12 11
0% 6 5.3 4.6 3.6
FY16 FY17 FY18 FY19 FY20 FY21 FY22
Corporates DII FII Individual investors PRO Others
Source: NSE. Data as at September 2021. : DII: Domestic Institutional Investors, FII: Foreign Institutional Investors, Prop traders: Proprietary Traders,
Individual investors: individual domestic investors, NRIs, sole proprietorship firms and HUFs, Others: Partnership Firms/LLP, Trust / Society, AIF,
Depository Receipts, PMS clients, Statutory Bodies, FDI, OCB, FNs, QFIs, VC Funds, NBFC, etc.
International investors’ exposure In addition, not all Indian stocks, even the largest ones,
to India are included in major benchmark indices. For example,
Unlike China’s onshore stocks, which only in recently HDFC Bank, a significant constituent of the Nifty 500
years have been phased into global equity indices, Index, is excluded from the MSCI India Index because of
Indian stocks have been included in major benchmarks foreign ownership restrictions in India’s banking sector.
for some time. However, the exposure investors get
through these indices might not necessarily be an Also, the exposure to India in global EM equity portfolios
optimal one. can vary significantly (Figure 16, overleaf) and is often
concentrated in the largest and most liquid stocks.
The MSCI India Index is the fourth largest constituent
of the MSCI Emerging Markets Index at 12% weight. Finally, international investors could be missing out
Even though the exposure to India via the broad EM on potential gains from IPOs, since it can take a fair
index is not insignificant, it is heavily skewed towards amount of time, up to 8 months, before new issues are
selected large-cap stocks. included in global equity benchmarks. This has been
very relevant recently, with a flurry of IPOs in India.
The case for a standalone India allocation 13T H E K E Y C H A RAC T E R I S T I C S O F I N D I A’ S S TO C K M A R K E T
Figure 16: Country allocation of largest GEM funds
60%
50%
40%
30%
20%
10%
0%
Argentina
Brazil
Cambodia
Chile
China & HK
Colombia
Cyprus
Czech Republic
Egypt
Estonia
Greece
United Arab Emirates
Hungary
India
Indonesia
Jordan
Kazakhstan
Kenya
Kuwait
Malaysia
Mexico
Nigeria
Pakistan
Panama
Peru
Philippines
Poland
Qatar
Romania
Russia
Saudi Arabia
Singapore
Slovenia
South Africa
South Korea
Taiwan
Thailand
Turkey
Ukraine
Uruguay
Vietnam
Source: Copley Fund Research, snapshot across managers as at 30 November 2021. Each dot represents the weighting in an individual GEM fund.
India’s tax on foreign investors’
capital gains
When investing in India, foreign investors should
keep in mind that India levies a capital gains tax on
the sale of equity shares, and also taxes the dividend
income earned on shares. The tax paid on the sale of
securities, and the tax rate itself, is dependent on the
holding period.
Additionally, there is a surcharge and a levy to be paid
over the basic tax rate. The rate of surcharge and levy is
dependent on the taxable income earned and the legal
structure of the foreign portfolio investor. Hence, the
rate of tax on capital gains can range from 10% to 21%.
Figure 17 (overleaf) summarises some of the details.
The case for a standalone India allocation 14T H E K E Y C H A RAC T E R I S T I C S O F I N D I A’ S S TO C K M A R K E T
Figure 17: Capital gains tax on foreign investors’ Improving sustainability reporting
capital gains by Indian companies
Historically, India has not been at the forefront of
Type of gains Tax Rate
the sustainable investment drive, partially due to
Short-term capital gains 15% plus applicable the sporadic ESG reporting from companies. Despite
(held for 12 months surcharge and levy this hurdle, international investors have been using
or less) internal models and databases to assess sustainability
factors, making it possible to follow a sustainable
Long-term capital gains 10%4 (without foreign approach to investing in India
(held for more than exchange fluctuation
12 months) and indexation) plus Now, sustainability is becoming increasingly important
applicable surcharge for Indian regulators. The Securities and Exchange
and levy Board of India (SEBI) has taken major steps to improve
data by standardizing the reporting process.
Dividend income earned 20% or rate as per the
on shares relevant double taxation From the financial year 2022-23, the top 1000
agreement (DTAA), listed companies in India by market capitalisation
whichever is favourable are required to file Business Responsibility and
plus applicable Sustainability Report (BRSR). This report has three
surcharge and levy
overarching ambitions: to adapt and mitigate the
impact of climate change, promote inclusive growth
Source: EY. Data as at February 2022.
4
In case of equity shares, the purchase and sale transaction is and transition to a sustainable economy.
chargeable to securities transaction tax and in case of domestic
equity oriented mutual funds, the sale transaction is chargeable to This should help investors to gather higher quality
securities transaction tax.
data and improve decision making on sustainability,
enabling them to better incorporate sustainability in
the investment process.
The case for a standalone India allocation 15T H E B E N E F I T S O F A N A D D I T I O N A L I N D I A A L LO CAT I O N
3. T
he benefits of an additional
India allocation
Given the unique characteristics of India’s economy, as well as the stock market,
we believe that India warrants a more central role within a broad EM strategy.
Below, we have highlighted the three key benefits of an additional India allocation.
An allocation to India can increase diversification Why would Indian equities have a lower correlation
First, in the broad asset allocation context, Indian than the broad EM benchmark? A key reason is
equities have added diversification to international that India has a large domestic economy, which is
equity portfolios. Figure 18 shows that the MSCI India not perfectly in sync with the global economy. For
Index has a correlation of 0.45 with the MSCI ACWI example, exports are 19% of India’s GDP. This is a
Index. While this is not insignificant in absolute terms, similar level to China, but much lower than in most
it is lower than the correlation of the MSCI EM Index other EM countries.
with global equities (0.69).
Hence, the fortunes of a lot domestic companies are
Furthermore, the correlation decreases when moving tied to India’s structural performance, rather than the
down the market cap spectrum, with the MSCI India global economic cycle, as is the case in some big EM
Small Cap Index having a correlation of 0.38 with the markets such as South Korea or Taiwan.
MSCI All Country World Index (ACWI). While it is true
that smaller stocks in general tend to exhibit lower Alpha opportunity, especially
correlation, the MSCI EM Small Cap Index has had a in the small-cap segment
much higher correlation with global equities at 0.65.
The second reason why a greater exposure to Indian
Overall, the diversification benefit of Indian stocks is stocks can be beneficial is evident when looking at the
not far off from the level of the diversification provided performance of Indian equity funds.
by China A shares, with the CSI 300 index having only a
Figure 19 (overleaf) shows the percentage of active
slightly lower correlation with global equities.
equity funds beating their specified benchmark (blue
bars) and the MSCI India Index (green bars), over
a three year period. We show the performance of
offshore and domestic funds, with the latter broken
down into large, mid and small-cap funds.
Figure 18: India has relatively low correlation with global equities
5 year returns
MSCI MSCI MSCI MSCI
MSCI India India India MSCI EM MSCI
India Large Mid Small EM Small ACWI S&P500 CSI300
MSCI India x
MSCI India Large 1.00 x
MSCI India Mid 0.90 0.87 x
MSCI India Small 0.88 0.86 0.91 x
MSCI EM 0.66 0.66 0.58 0.55 x
MSCI EM Small 0.72 0.72 0.66 0.67 0.90 x
MSCI ACWI 0.45 0.46 0.39 0.38 0.69 0.65 x
S&P500 0.30 0.30 0.26 0.25 0.49 0.45 0.95 x
CSI300 0.31 0.31 0.29 0.27 0.62 0.55 0.33 0.19 x
Past performance is not a guide to future performance and may not be repeated
Source: Schroders, Refinitiv Datastream. Data as at 31 December 2021. Daily return data in USD.
The case for a standalone India allocation 16Offshore India equity funds have done rather poorly, Interestingly, active performance improves
as only a quarter of the funds have managed to significantly when moving down the market cap
outperform the MSCI India Index. However, the spectrum. In the large and mid-cap segment, half of
performance of offshore funds is affected by India’s the funds have outperformed the MSCI India Index.
capital gains tax on foreign portfolio investors. This figure rises to 59% for mid-cap funds and to 95%
Accounting for the tax, the performance of offshore for small-cap funds.
funds would be better than post-tax returns indicate.
Importantly, the performance does not only
But even domestic large-cap funds, which are not reflect the fact that smaller stocks in general have
liable to the same capital gains tax, have struggled outperformed larger ones. More than half of small-
to beat their benchmarks. This again reflects the cap funds have also managed to beat their respective
concentrated nature of India’s stock market. mid or small-cap benchmarks.
One option to outperform the index when the market is Limited analyst coverage of
very top-heavy is to run a concentrated portfolio. While smaller stocks
this approach could pay off, it comes with additional
risks compared to a more diversified approach. What can explain the superior alpha generated by
funds focused on smaller stocks? Figure 20 (overleaf)
shows the average number of analysts’ earnings per
share (EPS) forecasts per stock, three years out, for
various Indian equity indices.
Figure 19: Percentage of funds beating their benchmark and the MSCI India Index over a three year period
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Offshore India India Fund India Fund Large & India Fund Mid-Cap India Fund
Equity Large-Cap Mid-Cap Small-Cap
Beating MSCI India Beating benchmark
Past performance is not a guide to future performance and may not be repeated
Source: Schroders, Morningstar. Data as at 31 December 2021.
The case for a standalone India allocation 17T H E B E N E F I T S O F A N A D D I T I O N A L I N D I A A L LO CAT I O N
Figure 20: Smaller stocks have much lower analyst coverage
Average number of analyst forecasts
30
25
20
15
10
5
0
MSCI India MSCI India Large Cap MSCI India Mid Cap MSCI India Small Cap
Fiscal year 1 Fiscal year 2 Fiscal year 3
Source: Refinitiv Datastream. Data as at 31 December 2021.
For the main MSCI India Index, there are on average done fairly good job in tracking the market. In fact, in
24 forecasts per stock for the next fiscal year. This is some cases, ETFs have actually managed to beat their
very high analyst coverage. As a comparison, in the benchmarks. This reflects the relatively low cost of
broad MSCI EM Index, there are on average 12 analyst index replication and good liquidity conditions in DM.
forecasts per stock.
However in EM, the picture is quite different. All EM
With such a large number of analysts following the ETFs have lagged their benchmarks. Given significantly
key stocks, it is likely that new information about higher fees of these ETFs compared to DM ETFs, this
companies will quickly be reflected in stock prices. is perhaps not surprising, with higher trading costs
further detracting from returns.
However, the degree of coverage starts to fall as you
move down the market cap range. Looking at the MSCI Looking at India, the underperformance has been very
India Mid Cap Index, it has on average 21 forecasts per high. Over the last three and five year periods, the
stock. But more importantly, analysts coverage really average India ETF has underperformed by -1.9% and
drops off in the small-cap range, with on average of 10 -1.8% per annum respectively.
EPS forecast per stock in the MSCI India Small Index.
Moreover, the underperformance is greater than that
The lower coverage among smaller stocks makes it implied by ETFs' expense ratios, pointing at the high
much more likely that active investors, who are willing cost of passive index replication in India. Granted, the
to put in the effort and do their homework, can correct returns are impacted by India’s capital gains tax on
and benefit from mispricings. foreigners. So the true performance of India ETFs is
more complex than indicated by the headline return.
For international investors, this clearly shows the
advantage accruing to onshore managers that have Finally, a passive approach might also not be an
the capacity to cover the small and mid-cap space. optimal one when considering equity valuations.
Aggregate valuations for the MSCI India Index are
A passive approach has not delivered currently among the most expensive valuations in
in India EM. A part of it reflects the fact that many companies
coming to market still have negative earnings, and as
While active managers have shown varying degrees
digital companies, carry high price multiples.
of success in India, a passive approach, on the other
hand, has missed the mark by a distance. Nonetheless, expensive valuations highlight the
importance of selectivity and differentiation between
Figure 21 (overleaf) shows the performance of various
companies, both of which are not available in a
equity ETFs in both EM and DM. We show the average
passive strategy.
excess return of the five largest ETFs by assets under
management in each category. In DM, ETFs have
The case for a standalone India allocation 18T H E B E N E F I T S O F A N A D D I T I O N A L I N D I A A L LO CAT I O N
Figure 21: A passive approach has not delivered in India
Average excess return of the five largest ETFs by assets under management
Asia ex Japan
China A shares
China
GEM
Global
India
Japan
Eurozone
UK
US
-2.5% -2.0% -1.5% -1.0% -0.5% 0.0% 0.5% 1.0%
5y Excess Return (Annualised) 3y Excess Return (Annualised)
Past performance is not a guide to future performance and may not be repeated
Source: Schroders, Morningstar. All returns in USD. Data as at 31 December 2021.
Given India’s growth potential, the emergence of the new digital economy and
vibrant domestic stock market, investors should consider a satellite allocation to
India, in addition to a broad emerging markets allocation. Such a strategy would
allow investors to capitalise on the opportunity in a large and liquid stock market,
as well as increase diversification in global equity portfolios. Indian stocks can also
offer an alpha opportunity that is available only in a flexible strategy.
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