NRI Talk: Why NRIs are increasing equity allocations in their investment portfolios

“Over the last five years, equity allocation by NRIs have increased significantly, bolstered by recent performance,” says Shantanu Bhargava, Head-Listed Investments, Waterfield Advisors.

In an interview with ETMarkets, Bhargava said: “NRIs also have a strong interest in unlisted equities, with significant allocations to direct unlisted securities,” Edited excerpts:

Thanks for taking the time out. How are NRIs looking at India as an investment destination?
Shantanu Bhargava: For NRIs, India's strong economic growth and macroeconomic stability have made it a very appealing place for investment. They are attracted by economic development, which presents opportunities in a variety of ways.

Despite recent blips and underperformance, they are sold on the long-term story. Additionally, our equity markets have delivered very strong performance in recent years, which is attracting NRI investors.

A related point is that if one were to look at the long-term performance of large economies over the past 15–20 years, the USA and India have been the primary players.

For NRIs, other alternatives like China and other emerging market avenues have not yielded much in terms of returns.

Lastly, for NRIs, it is not just about making money; it is also about staying connected to their roots and helping the country grow. For many, there is an emotional connection as well.

To add, two significant factors contributing to this heightened interest are policy certainty and currency stability. These factors are often overlooked, but political instability and frequent policy changes create uncertainty for investors.

Post-2014, India has offered political stability, which is a key consideration for NRIs planning long-term investments.

On the policy continuity front, if we look at the double tax avoidance agreements (DTAAs) India has with major countries, there hasn’t been a change since 2021. This stability provides a peaceful environment for NRIs to operate.

The second major factor is currency stability. At the start of the previous decade, the rupee was prone to wild swings. For example, during the 2013 Fed taper tantrum, there was significant depreciation of the INR against the US dollar, which made NRIs anxious.

Planning long-term investments was challenging because currency depreciation eats into overall returns, especially for those investing on a repatriable basis.

We have come a long way from those days. The current administration and the central bank have done a great job of managing fiscal math and regulating the currency, giving NRI investors confidence to enhance their investments in India. Over the last five years, the INR has been far more stable compared to other currencies relative to the US dollar.

Now, NRI investors typically factor in a rule of thumb of 3–3.5% for currency depreciation, which is par for the course. Because they are no longer experiencing the wild swings of the past, they have greater confidence to invest for the long term.

How are HNIs/UHNIs managing wealth apart from equities? What other investment options do they include in their portfolios?
Shantanu Bhargava: Savvy investors, particularly those backed by skilled advisors, understand that future equity returns are likely to be modest compared to what they experienced in the last five years. Therefore, they are broadening their portfolios to include a range of asset classes.

One trend we’ve noticed is an increased allocation to sticky, yield-bearing, non-equity asset classes like InvITs, REITs, and high-yield fixed income products such as venture debt and performing credit. Additionally, there is some interest in defensive assets like gold.

On the private side, there is massive interest in pre-IPO opportunities. For instance, Swiggy's recent debut on the exchange was a favored investment avenue in the recent past. The more focused and disciplined HNIs are increasing their exposure to private markets through VC and PE funds, although not all of them are doing so.

It’s also worth highlighting a trend among new investors who began investing after 2020. These investors have witnessed outsized returns in public equities.

Furthermore, the change in debt mutual fund taxation in 2023 created a TINA (There Is No Alternative) factor. As a result, these newly minted investors continue to prefer equities alongside some opportunities in the pre-IPO space.

What are the key investment trends among NRIs in India today, and which sectors or asset classes are currently most attractive to them?
Shantanu Bhargava: In the previous decade, if we go back 10 years, NRIs primarily concentrated on dollar debt issued by Indian corporates.

Their focus was on bonds issued by large banks with global offices, such as Axis, SBI, and HDFC, as well as bonds issued by corporations like Reliance, JSW, and Vedanta. That used to be their primary play.

Since 2019, however, NRIs have shifted their focus to India as a primary equity investment opportunity. There are two key shifts here.

The first is in India's geographical weight within their overall allocation, which used to be around 15% but has now grown to 20-25%.

The second is in their asset allocation within India, moving from a predominantly debt-focused allocation to one more equity-oriented. Over the last five years, equity allocation has increased significantly, bolstered by recent performance.

NRIs also have a strong interest in unlisted equities, with significant allocations to direct unlisted securities.

Their affinity for NRE FDs and real estate continues, though interest in real estate has waned in recent years. Additionally, they have begun exploring asset classes like REITs.

We are almost coming to the end of 2024 – any key learnings you would like to share?
Shantanu Bhargava: First, investors should avoid chasing yields in high-yield debt products, which is a trend that concerns us to some extent. The change in taxation of debt funds in 2023 coincided with a strong credit cycle.

This environment, marked by improved corporate earnings and cleaner balance sheets, has led to the emergence of various high-yield fixed-income products. These range from performing credit, involving investment-grade bonds, to more complex opportunities like distressed debt.

As future equity returns moderate, the trend of seeking higher yields from credit opportunities is likely to grow. However, this is also the time when the seeds of mistakes can be planted. For example, the credit mutual fund issues of 2018 had their origins in decisions made as far back as 2013.

The key is that investors should not view the entire credit space as homogeneous. In the search for yield, they must avoid investing in securities they do not fully understand, especially in areas like distressed debt or special situations.

It is critical to make informed decisions by understanding the security package, the sectors the fund is focused on, and the track record of the management team.

Second, betting against the Indian equity market with an aggressive cash position is fraught with challenges.

While maintaining some cash for tactical purchases is reasonable, deep cash positions can harm a portfolio’s prospects and set up investors for mistakes.

For example, during the market weakness we experienced starting in October, many investors shifted from being ultra-bullish at the end of September to becoming extremely cautious. Instead of continuing with systematic deployment strategies, they turned to timing the market, which can be detrimental.

Lump-sum investments can be avoided, but investors must continue regular investments to bridge gaps in their current allocation. For instance, professional fund managers faced challenges this year due to the extended run-up in mid-cap and small-cap indices.

Many fund managers who took a cash call early in the year locked in underperformance relative to benchmarks. If they now give in to FOMO and take aggressive positions to recover, it could harm their clients.

Finally, another key learning is the lack of sufficient diversification in non-equity asset classes such as gold, InvITs, and REITs. While many investors have dipped their toes into these areas, they remain under-allocated, which poses risks in the "new normal" as the journey ahead is expected to be more challenging.

How have geopolitical and economic factors influenced NRI investment preferences in the Indian market?
Shantanu Bhargava: Going back to my previous points, an analysis of the long-term performance of global stock markets over the past 20 years indicates that India and the US have emerged as the predominant markets, and this is reflected in how most investors have allocated their money.

The underperformance of markets such as China, attributed to various geopolitical and economic factors as they undergo their own transformation, has benefited India and contributed to the significant surge in investments directed toward us.

I would also like to highlight the impact of government policy. The government’s foreign policy and its adept management of various geopolitical issues, including platforms such as the G20, have significantly influenced the country’s perception globally. This has resulted in favorable outcomes.

We often speak to counterparties in other countries like the US, and the government’s outreach efforts over the past 10 years have markedly changed the perception of India, attracting more capital in our direction. The underperformance of other markets like China has further amplified this trend.

Are you seeing a shift in NRIs' interest from traditional investments like real estate to financial instruments such as mutual funds or equities?
Shantanu Bhargava: Yes, most definitely. Even in traditional strongholds of real and hard assets, such as Kerala—where, until a few years ago, it was a struggle to discuss equities with investors because their favored investments were land, hard assets, real estate, and maybe FDs—we have seen an increased allocation to financial instruments like equities, mutual funds, and stocks. Clearly, there is a shift.

How do you see the industry in the next 3 years?
Shantanu Bhargava: I will highlight three trends.

The first is a very pronounced increase in allocation to alternative investments.

According to a study, HNI and ultra-HNI wealth in India is expected to double to USD 2,000 billion by 2027. This will drive demand for alternatives. Currently, the market manages close to Rs 34 lakh crores in alternate assets, which include private markets and complex strategies.

With the growth in HNI wealth, the demand for alternatives will rise, and I believe the AUM of alternates could be 40-50% higher than it is today within the next three to four years. This mirrors global patterns, where the share of alternates surged from 10% to 20% between 2005 and 2020.

The second trend is the impact of the "MF Sahi Hai" campaign, which has been phenomenal. I believe it will continue to yield positive results.

Considering the current penetration of equities in the overall household investment balance sheet, the surge in general affluence, and increased awareness among investors—demonstrated by their maturity in October when markets dropped by 6% but retail investors were net buyers—I firmly believe the trend of regular investing will grow.

The monthly SIP numbers should increase by 25-30% from the current monthly run rate of ₹25,000 crore within the next three to four years. Lastly, as a firm, we are very excited about the emergence of a new asset class introduced by SEBI: the Specialized Investment Fund.

This class accepts investments of ₹10 lakhs or more and is designed for high-risk takers. While more details are awaited, this promises to be a very exciting space, offering the best of both worlds for investors. For sophisticated strategies, it will be a great addition and may also provide tax advantages that platforms like PMS and AIFs do not currently enjoy, but mutual funds do. We are quite enthusiastic about this category.

What specific tax benefits can NRIs avail themselves of when investing in AIF Funds?
Shantanu Bhargava: I will talk about Category II and Category III AIFs. Category II AIFs in India have a pass-through status, which means the income earned by the fund is not taxed at the fund level but is passed on to the investor.

The investors are then taxed based on the nature of the income. Category II AIFs typically focus on diversified investment opportunities across asset classes, including debt and real estate.

Category III AIFs, on the other hand, do not have a pass-through tax status. This means the income earned by the fund is taxed at the fund level, and investors are not taxed on the income earned by the fund at their level. These funds can employ trading strategies, take derivative positions, and utilize complex strategies.

The advantages and disadvantages of AIFs as a vehicle may vary based on the country of residence of the NRI.

For example, in countries like Singapore and the UAE, there are favorable tax treaties for investments in equity-oriented mutual funds, making mutual funds the most tax-efficient vehicle for NRIs residing in these regions. In fact, AIFs and PMS products are less tax-efficient compared to mutual funds in these cases.

However, for US-based NRIs, who face the complication of PFIC (Passive Foreign Income Complication), where gains are treated as ordinary income and taxes are paid on unrealized gains, AIFs can be a better vehicle. This is due to the issuance of a specified K-1 statement, which makes AIFs more tax-efficient compared to mutual funds for US investors.

The choice of the right investment vehicle depends on the country of residence of the NRI. For US investors, AIFs are often a better option. For those in Singapore, UAE, or the UK, the tax treaties need to be carefully interpreted to determine the most suitable investment vehicle. It is a nuanced decision that requires expert guidance.

What are the key regulatory challenges NRIs face when investing in India, and how can they overcome them?
Shantanu Bhargava: While I cannot predict what may be introduced in the budget, I can speak about the overall regulatory environment. Over the years, the regulatory environment has improved.

For instance, SEBI has merged the investment limits for NRIs and FPIs, allowing NRIs to participate in FPIs subject to certain conditions. This merger has simplified the investment process, providing NRIs access to professional fund managers, and it has been well-received.

However, there are still areas that require careful attention. For newly designated NRIs, stock market investments require setting up specific bank accounts (NRO, NRE) and a PIS account.

There are also restrictions on real estate ownership, as NRIs cannot invest in all types of real estate in India. Comprehending and completing the required documentation can be time-consuming and often requires expert assistance.

Investment options for NRIs are more limited compared to resident Indians. For example, there are restrictions on some mutual fund schemes, certain debt mutual funds investing in bonds, and derivative trading. NRIs need to be mindful of these restrictions to avoid potential pitfalls.

Taxation is another crucial aspect. India has a Double Taxation Avoidance Agreement (DTAA) with 85 countries. NRIs must understand the specific provisions of these treaties and claim benefits accordingly.

Many NRIs are unaware of the beneficial covenants in these tax treaties and end up paying more taxes than necessary.

It is essential for NRIs to seek expert guidance for paperwork, identifying suitable investment instruments, and decoding the tax treaties to navigate these challenges effectively.

(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)