US Markets and Why Exposure to That Is a Necessary Evil for Diversification

By: Tavaga Research

Like every other stock market in the world, the US stock market is made up of many equity indexes with NASDAQ Composite, the S&P 500 and the Dow Jones Industrial Average (DJIA), the most largely followed indexes. In total, the US equities are made up of 5000 indexes, with the Wilshire 5000 index made up of all the stocks from the US stock market.

The S&P 500 Index

The biggest equity index of the top 500 companies of the U.S., the Standard & Poor’s 500 (popularly known as the S&P 500), is an index that represents almost 80% of the total value. If an investor wants to invest in something easy to quantify and broad-based, then the S&P 500 is the one. Thus, speaking in generic terms, the S&P 500 gives a clear indication of the direction of the U.S. market. 

The NASDAQ Composite Index

The NASDAQ Composite Index is market-capitalization-weighted made up of the top 100 non-financial stocks. It is a tech-heavy, growth-oriented index with telecommunication, consumer durables, and biotechnology also forming the part of the index. The NASDAQ Composite gives a good indication of the performance of the technology sector.

The Dow Jones Industrial Average

Commonly known as the DJIA, the Dow Jones Industrial Average is a price-weighted index and one of the oldest in the world. The index is made up of stocks of 30 of the largest companies in the U.S. It is owned by the NASDAQ and tilts more towards the conservative side and hence generates income in the form of dividends than capital appreciation.

What Has One Missed By Not Investing In US Equities?

It is a wrong perception that India being one of the fastest-growing economies, the Indian stock market will always perform better than the other developed markets. In fact, the returns generated from the S&P 500 have beaten the Nifty 50 returns many times. The world has become a smaller place due to globalization and with the increasing usage of internet data, Indians know a lot of things. Markets today are wide open because of liberalization. However, there is a typical Home Country Bias, not only restricted to Indians but it is observed everywhere in the world. Home country bias is a behavioral bias where the investor only prefers to invest in the companies of his own country over the companies from other nations. 

There is a lot of scope for dollar hedge investing by accessing the U.S. markets. By investing in U.S. equities, an average Indian not only gets access to quality assets abroad but also benefits from a weaker rupee (The Indian rupee has depreciated approximately 4% every year against the U.S. dollar). For simplicity, let us compare the charts of the NASDAQ Composite and the Nifty 50 index.

Performance comparison between the Nasdaq Composite Index and Nifty 50 Index

As seen in the above chart, the NASDAQ has gone up more than 5 times in the last 10 years, whereas, the Nifty 50 has just more than doubled. As long as the inflation in India is greater than the inflation in the U.S., one can expect the rupee to get weaker and weaker. As long as India remains a growth economy, inflation at some levels is truly justified and hence one can expect the dollar to appreciate further.  

The dollar-rupee parity is such that if an Indian investor would’ve invested abroad, a 4%-5% extra return would’ve been made only because of rupee depreciation every year. To put it in simpler terms, the NASDAQ Composite index has gone up more than 5 times, whereas, the Motilal Oswal NASDAQ 100 ETF (listed in India) has gone up more than 7.5 times in the last 10 years and this was possible only because of rupee depreciation.

Performance comparison between Nasdaq Composite Index and Motilal Oswal Nasdaq ETF

Why are US Markets Necessary for Diversification?

1. Low Correlation: The idea behind portfolio diversification is that there should be very little or no correlation between asset classes or financial instruments and thus reduce portfolio risk. A correlation of 1 implies a perfect positive correlation wherein the assets move in tandem (in the same direction) while a negative correlation is anything between 0 and -1 indicating movement of assets in the opposite direction. Over the last 20 years, the correlation coefficient of the U.S. to India is closer to 0 implying absolutely no linear relationship between the two markets. The same is the case between the yields of sovereign debt of two countries. Post Donald Trump’s victory in 2016, the sovereign bond yields shot up more than 20 basis points in the U.S., however, India saw a fall of more than 50 basis points.
2. Standard Deviation: Historically, the standard deviation of the Sensex as compared to the DJIA (Dow Jones Industrial Average) has been consistently greater on multi-year comparisons. Data from Index Factsheets suggests that over the 3 years, 5 years, and 10 years horizon, the Sensex has witnessed more volatility and swings as compared to the DJIA.

Ways and means to invest in U.S. Equities

1. Exchange-Traded Fund: Motilal Oswal Asset Management Company offers passive investment in the NASDAQ Composite index via exchange-traded fund for which a demat cum trading account must be opened with a stockbroker.
2. Mutual Fund: Many asset management companies operating out of India are currently offering active as well as passive investments in U.S. equities via various mutual fund schemes.
3. Open a Trading Account with an Indian Broker: Some brokers from India have tie-ups with foreign brokers who act as an intermediary allowing domestic investors the access to the primary and secondary market of the U.S.
4. Open a Trading Account with a foreign broker:  The process of investing directly with a foreign broker is quite similar to the domestic investment process but with differences in the commission.

One must realize that the recent discussions about the decline in globalization are a short-term phenomenon and allocation must be made to global equities as it tremendously helps in hedging the depreciating rupee, diversification and also provides access to quality businesses. India’s GDP as compared to the world standards is at 3% of the global GDP and if one looks at an average Indian’s investment portfolio, all the investments are in that 3% while ignoring the rest 97%. So by investing in the S&P 500 companies whose 40% of sales come from countries other than the U.S., one is getting exposure to 20%-25% of global GDP making the portfolio in line with where the world is evolving. 

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