Again, Government Has India ETFs at Crossroads

It has been a volatile year for India ETFs and that is a kind assessment. Year-to-date, the iShares S&P India Nifty 50 Index Fund INDY, the WisdomTree India Earnings ETF EPI and the PowerShares India Portfolio PIN are sporting an average gain north of 14 percent. The downside of those gains is that investors have had to endure a roller-coaster ride on the way to the bank as EPI and INDY both have volatility metrics above 25 percent. PIN rests at 26 percent. As is the case in many other emerging markets, a large part of the reason for India's underlying volatility is the country's government and its role in day-to-day economic perceptions. After getting off to a fine start in the first quarter, India ETFs such as EPI, INDY, PIN and others tumbled on speculation the country was primed to lose its already tenuous investment-grade credit rating. At BBB- on the Standard & Poor's ratings scale, India has the lowest credit rating of the four the BRIC nations. In April, S&P lowered its outlook on that rating to negative prompting some analysts and investors to say the government in Asia's third-largest economy had turned a blind eye to the country's economic woes. Investors' fears would later be somewhat assuaged when the government once accused of doing nothing to bolster its economy and foreign investment gave investors reason to cheer. India ETFs would soar for most of the third quarter after the government unveiled an array of economic reforms aimed at stimulating growth and investment. Those reforms included opening India's massive insurance and retail sectors to additional foreign investment, reduction of the country's punitive diesel subsidy and the injection of added liquidity into the banking system. Those headlines were enough to lift the fortunes of India ETFs and not just the well-known fare such as the aforementioned funds. The EGShares India Small Cap ETF SCIN, the EGShares India Infrastructure ETF INXX and other India funds benefited from the government reforms. Fast-forward to today and government that oversees the world's largest democracy is once again likely to have a heavy hand in near-term returns to India ETFs. India is grappling to keep its fiscal deficit to 5.3 percent of GDP in a bid to keep its investment-grade rating. The country is looking to pare the deficit 0.6 percent annually for the next five years, Bloomberg reported. Whether or not traders are pricing in a credit downgrade for India can be debated, but what can not be debated is that the yield's on Indian 10-year sovereign bonds touched a two-month high earlier this month. The spread between those bonds and the comparable U.S. Treasuries is about 650 basis points. Despite the size of its economy, India is not nearly the bond issuer, either at the sovereign or corporate level, that China is. At the ETF level, that translates to small weights in some of the marquee emerging markets debt ETFs, meaning investors can get some exposure to Indian bonds without being excessively exposed to a potential credit downgrade. For example, the WisdomTree Asia Local Debt Fund ALD allocates less than 5.7 percent of its weight to India and that is one of the larger weights to Indian government debt offered by any U.S.-listed ETF. Remembering that failing to prepare is preparing to fail, investors can prepare for the worst-case India scenario. That being that the country sees its credit rating moved to junk status. Assuming that happens, ETFs with large exposure to high-beta sectors such as financials and energy could be vulnerable in the near-term. Avoiding financials with Indian large and small-cap ETFs can be tricky as the sector is often the largest in both types of funds, so focusing on India's domestic demand story could prove to be the winning bet. It does not get much attention, bu the EGShares India Consumer ETF INCO is the best-performing India ETF year-to-date with a gain of nearly 41 percent. Roughly 53 percent of INCO's weight is devoted to makers of personal goods, food and beverages which is to say the ETF is not a play on what Indian consumers, but rather on what they need. Despite its almost 26 percent weight to financial services names, the newly minted iShares MSCI India Small Cap Index Fund SMIN merits consideration as well. Nearly 24 of that fund is directly exposed to the consumer and another 19 percent goes to health care and utilities names, so SMIN is not ultra-risky at the sector level. There is one more new ETF that is worth a look even if India heads to junk status. The EGShares Emerging Markets Domestic Demand ETF EMDD focuses solely on companies that are levered to the domestic demand stories in various emerging markets. That means a couple of important things. First, U.S. multinationals such as Coca-Cola KO are not included in this ETF. Second, India merely accounts for 15.3 percent of EMDD's weight, so there is adequate coverage for investors should Indian stocks decline. Of course, it is worth noting India and China combine for about 30 percent of EMDD's weight and that is important because the two countries could have combined consumer spending of $10 trillion annually by 2020. For more on India ETFs, click here.