The Indian equity market reached new highs in 2014, with the MSCI India gaining close to 25%. However, investors with a passive exposure may be missing a good opportunity to earn extra returns, due to the specific nature of the Indian equity market.
India: a stock picker’s paradise
While it is estimated that barely 30% of active funds manage to outperform their benchmark over a five year horizon, in India the situation is actually the opposite. Based on publically available information, 67% of local Indian equity mutual funds outperformed their benchmark over three years and an impressive 75% of funds managed to outperform over five years.
A favourable market for skilled mutual funds managers
While in the US and many other global markets, mutual and pension funds are so large that they drive the market with investments that tend to reflect the indices. In India mutual funds schemes remain relatively small compared to the overall market. Even the largest local equity mutual fund, with around USD 2.6 billion in assets, barely represents 0.17% of total market capitalisation. As a consequence, equity fund managers don’t have a significant impact on market prices, making it easier for skilled fund managers to outperform the index.
International investors: overcoming international indices’ flaws
Choosing an active manager can be even more beneficial for international investors, as their investments in India are usually measured against international indices, primarily MSCI India index or one of its varieties. While most sectors in India allow 100% foreign ownership, the limit for private-sector banks is set at 74%, with a sub-limit of 49% for foreign portfolio investments.
Private sector banks have been one of the most dynamic segments of the Indian economy. From 3.5% in 2000, their market share, as measured by low cost deposits, has moved to 17.7% and is expected to continue to grow in the years to come. As these private-sector banks gained popularity amongst foreign investors, more and more of them have hit foreign ownership limits, leading to their gradual exclusion of MSCI indices. For example, India’s largest private-sector bank HDFC Bank moved from being the fourth largest weight in the MSCI India 10/40 index with a commanding 7.35% weight as of end of 2013, to being removed from the index in November 2014. The situation is such that today, all but one private-sector banks have been removed from the MSCI indices, whereas they still represented close to 10% of the index less than a year ago.
Source: RBI, RIMES, MSCI, January 2015.
Private-sector banks are expected to be among the top beneficiaries of the reacceleration of growth in India and experience improved liquidity conditions due to the central bank’s progressive easing. Their removal in international indices provides one more reason for international investors to use an active manager with flexibility to invest in out-of-benchmark positions, in order to get a full exposure to India’s exciting recovery story.
 Source: S&P Indices Versus Active Fund 2014 report. Over five years ending in June 30, 2014, respectively 74% of global active funds, 70% of international funds underperformed and 68% of emerging-market funds underperformed their benchmark.
 Source: BNP Paribas Asset Management, Reserve Bank of India, January 2015.
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