Investor Q&A: Should I invest in Motilal Oswal S&P 500 Fund to get exposure to the US stock market?

Q. For several years I have been looking for some exposure to the US markets. Yesterday I learnt of Motilal Oswal's S&P 500 index fund. I was wondering if it will be available on Goalwise any time soon.

I would also welcome any thoughts/opinions you might have on getting exposure to the US market through this fund, are there any caveats I should be aware of?

Motilal Oswal S&P 500 Index Fund is currently in its NFO period and will be open for subscriptions by the end of the month (29th April 2020). It will be available for custom investments on Goalwise then. It's also currently available on Goalwise as an NFO (its NFO period ends on 23rd April, 2020).

Currently you have three options for getting exposure to US stock markets:

1. Active funds investing in both Indian and US equities

The best example is Parag Parikh Long Term Equity Fund which invests up to 35% in international equities (predominantly US) while keeping 65% or more in Indian equities. This allows the fund to be classified as an equity fund for taxation purposes (otherwise international funds are classified as debt for taxation).

However, for the international investments, this fund takes very concentrated positions in a handful of stocks instead of a broadly diversified portfolio (like the S&P 500). For eg. as of 31st March 2020, there were only 5 international stocks making up 35% of the fund's portfolio.

2. US focused active mutual funds

These are mutual funds that either invest in US stocks directly (e.g. ICICI Prudential US Bluechip Equity Fund) or fund of funds that invest in a US based active equity mutual fund (e.g. Franklin India Feeder Franklin US Opportunities Fund investing in their overseas Franklin US Opportunities Fund). As per our existing tax rules, their taxation will be similar to debt (and not equity).

3. US focused Index funds

These are funds that track their corresponding US based stock indices e.g. Motilal Oswal NASDAQ 100 FOF or the newly proposed Motilal Oswal S&P 500 Index Fund.

These funds simply mimick their respective indices and match their returns while charging minimal fees.

Like other international funds, capital gains in these funds will also be taxed as debt.

Which option should you choose?

In our opinion, out of these three options, US focused index funds viz Motilal Oswal NASDAQ 100 FOF and Motial Oswal S&P 500 Index are the cleanest and the cheapest way to take exposure to the US stock markets (even though it is not very tax efficient as international funds get taxed as debt).

Why an index fund?

The US stock markets are considerably more mature and efficient than Indian stock markets so it is very difficult for active fund managers to beat a diversified benchmark like the S&P 500.

In fact, according to the latest SPIVA report - which tracks the performance of active US equity funds vis-a-vis their benchmarks - 80% of the funds under-performed the S&P 500 over the 5-year period ending Dec 31, 2019.

Given this context, it is better to invest in an index fund which one doesn't need to change rather than trying to identify which small group of active funds will outperform (and then keep changing them as their performance wanes).

Also, the expense ratio of index funds are much lower as compared to their active counterparts e.g. the all-in expense ratio of Motilal Oswal NASDAQ 100 FOF's direct plan is just 0.6% (FOF + underlying ETF). Similarly the proposed expense ratio of Motilal Oswal S&P 500 index fund is 0.5%. On the other hand, expense ratio of ICICI Prudential US Bluechip Equity Fund is 1.79% - almost 3 times higher!

NASDAQ 100 or S&P 500 - what's the difference?

The Nasdaq 100 Index is a basket of the 100 largest, most actively traded U.S companies listed on the Nasdaq stock exchange. The index includes companies from various industries except for the financial industry (eg commercial and investment banks). These non-financial sectors include retail, biotechnology, industrial, technology, health care, and others. Technology sector accounts for 54% of the index's weight, followed by consumer services at about 25%. (Investopedia)

On the other hand, the S&P 500 or is an index of the 500 largest U.S. publicly traded companies. The index is widely regarded as the best gauge of large-cap U.S. equities. It is a more diversified index as compared to NASDAQ 100. Technology is still the biggest sector but it accounts for only about 25% (vs 54% in NASDAQ), followed by healthcare (15%) and financial industry (10%).

The choice between the two is essentially about over-weighting the tech industry and under-weighting the financial industry. You can take your pick as per your investing beliefs or invest in both.

Caveats for Motilal Oswal S&P 500 NFO

The usual caveats of investing in a new index fund apply - mainly that the tracking error is unknown.

What is tracking error?

Running an index fund especially an overseas one requires a good deal of operational expertise and this get reflected as tracking error which is the deviation of the index fund returns from that of the index itself.

There is always going to be some tracking error (e.g. due to expense ratio, holding cash in the portfolio to meet day to day redemption needs) but it could be more because of operational difficulties.

Since the fund is new, we don’t have any history to go by. Having said that, Motilal Oswal have been running a Nasdaq index ETF since 2011, so they do have some expertise in this area and I won’t be too worried if I am just starting my investments at this point. It can always be reviewed later.

Points to note while investing in international funds

More importantly, there are some caveats to investing in international funds that you should be aware of and make a fully-informed choice:

a) Taxation will be as per debt and not equity - this is just the way it is currently.

b) Adding international exposure is a good way to diversify but diversification does not mean higher returns. Diversification means average returns with reduced risk as both the investments are expected to move somewhat differently. In other words, diversification means settling for the average by giving up on both the best and the worst case.

c) Going forward, returns from US markets could be lower than that from India (even including the exchange rate movement). Or the other way round. No one really knows (otherwise why even invest in India). So, don’t do it thinking you will get higher returns vs investing in India. That’s just what has happened in the last decade or so. Future can be different. Do it only to reduce your portfolio's over-dependence on the Indian economy and markets.

d) There are bound to be periods where returns of Nifty/Sensex are going to be higher than that of S&P 500/NASDAQ 100. And this will have a psychological impact on you especially when many of your friends would have just invested in India and enjoyed higher returns for that given period. If that is going to lead you to question your decision of investing in the US, then you might as well not do it as it WILL happen. Remember, diversification does not increase returns. In fact it lowers returns to the average of all the investments. Don't fall prey to irrelevant benchmarks (e.g. your friend's portfolio).

Hope that helps. If you have any further questions, feel free to write to us. :)