Capitalize On India: INCO vs CEF

We previously highlighted an opportunity with India. Specifically, we discussed the ETF INCO, which focuses on the Indian consumer. Since India is expected to become the home of the world’s largest population, and one of its largest middle classes over the next decade.

india eft investment

Since the emerging middle class is booming in India, the consumer sector, and investments like INCO seem ideal. Following on that, we wanted to offer up another specific India suggestion. While ETFs are a popular way to play the space, we think there is a CEF that is appealing as well in this case.

A CEF, or closed-end fund, is a fund that invests with a mandate toward something, in this case India. Closed-end funds tend to be like ETFs in that they own a large basket of stocks, trade throughout the day (unlike mutual funds), and pay regular dividends and capital gains distributions.

The big difference between ETFs and CEFs tends to be that CEFs tend to trade at a discount to their underlying asset value. In this case, the CEF we’re looking at, the India Fund (IIF) trades at a roughly 12% discount to the value of its underlying assets.

In short, you’re buying a dollar’s worth of underlying assets for just 88 cents. That’s a nice deal compared to say, an ETF, where a dollar’s worth of assets trades for a dollar. Since ETFs can be hedged and arbitraged more easily, they tend to trade right at fair value most of the time.

As a disadvantage, CEFs often have higher expense ratios than ETFs. In this case, the expense ratio for IIF is significantly higher than a comparative ETF, such as the iShares MSCI India ETF (INDA). The difference is about .7% a year, significantly less than many ETF/CEF gaps, since the MSCI country ETFs tend to have high fees anyways.

So, over time, IIF is likely to experience lower returns due to the higher expense ratio, all else held equal. However, you start with a 12% advantage from having bought a dollar’s worth of assets at 88 cents.

What will be the catalyst for the India Fund to return to full value? There’s nothing that would force it to trade up to its true value. However, CEFs tend to trade up and down based on investor sentiment, since there is a fixed number of shares outstanding, as demand for an investment theme rises and falls, the CEF’s premium/discount to its true value will similarly oscillate.

When India becomes more popular with investors, the CEF should benefit doubly, first from its assets appreciating in value, and second from the discount to its true value being reversed. If India rises 20% and the discount to valuation also normalizes, you make more than 30%, instead of just 20%.

And we think India is going to come back into favor soon. With Russia and Brazil facing sharp declines from the commodity bust and the Chinese boom hitting strong turbulence, India now stands as the strongest of the BRIC economies. For investors looking to allocate to emerging markets but wanting to avoid the Chinese slowdown and related commodity collapse, India is the ticket.

This has been partly reflected already, India shares have had a mediocre 2015, but compared to countries like Russia and Brazil, they have fared relatively well. Already a leader, since its shares have been emerging market outperformers, we expect shares to leap higher when the tide turns more positive for emerging markets again. Stocks that hold up best in hard times tend to spring higher once the tide turns.

India, unlike many foreign countries, is a huge net importer of oil and commodities. It is one of the biggest direct winners from the collapse in oil and base metal prices.

GDP continues to grow at a solid 7% clip, inflation has plunged into the 3% range, and the Indian Central Bank is considering near-term rate cuts that would provide another boost to the economy.

In the long run, India has a bright future based on promising demographics, and slow but meaningful improvements in governance and infrastructure. Indian shares have been in a lull in recent years as weakness in emerging markets has soured investors to the whole BRIC theme.

We expect this to reverse in coming years, if not quarters, and recommend considering Indian positions now. We like IIF because it trades at a sharp discount to its asset value: an 88 cent dollar. For those that prefer ETFs or that want a more consumer-focused play, we still like INCO as well.

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