IIF - IIF: An Unfairly Penalized Active Indian Fund

2023-12-05 05:07:53 ET

Summary

• Morgan Stanley’s India Investment Fund has extended its relative outperformance this year.
• Yet, the market has continued to punish fund investors, pricing shares at a record-high NAV discount.
• Patient investors could reap a few extra percentage points of performance with IIF over time.

Since the broader selloff in Q1, Indian equities have benefited from improving news flow in recent months, indicating consensus is finally coming around. As the most populous country, the IMF now sees a clear path to India’s fast-growing economy eventually taking over the third-largest mantle by 2027. It’s hard to argue against a sustained high-single-digit % GDP growth algorithm going forward, given the many secular tailwinds at hand. And as India’s capital markets continue to mature (vs the current bank-dependent economy) and benefit from more index inclusion catalysts for its government bonds, there is a clear path to a structurally lower cost of capital longer-term.

Holding on to quality large-cap stocks seems like the best play here, given the lower downside risk vs. small/mid-caps and their more palatable valuations relative to underlying earnings growth. Unlike in more mature markets, stock selection can also make a big difference in India, as the MS India Investment Fund’s ( IIF ) track record of outperformance shows. Yet, since I last covered the fund, the market has further punished IIF, widening its net asset value discount to a record 19-20%. From here, patient investors willing to bet on convergence to historical levels, helped by an ongoing buyback program (currently running at a mid-to-high-single-digits % annualized pace), stand to be well-rewarded, in my view.

India Investment Fund Overview – Concentrated but Backed by a Robust Stock Selection Process

The continued resurgence in Indian stocks through Q4 has floated all boats, with the closed-end Morgan Stanley ( MS ) India Investment Fund experiencing a further expansion of its asset base to ~$284m (up from ~$282m prior). The expense ratio is unchanged, though, at 1.4% gross (1.3% net), while the annual management fee stands at 1.1% - in line with the largest US-listed India active fund, the abrdn-managed India Fund ( IFN ) (see prior coverage here ). Both funds use a fundamentals-focused approach, though IIF also integrates a top-down overlay to its stock selection process. The lead manager remains long-tenured Amay Hattangadi, who co-manages three other Morgan Stanley emerging market portfolios – the Global Emerging Markets Equity Strategy, Sustainable Emerging Markets Strategy, and the China A Equity Strategy.

IIF has added one stock to its portfolio over the last quarter, bringing the fund’s total individual holdings to 41. Financials remain the largest sector allocation at an increased 42.3%, followed by Consumer Discretionary (also increased to 15.5%) and Information Technology (down to 8.2%). Energy (6.8%) is now the fourth-largest sector exposure, gaining share over fifth-placed Industrials (down to 6.8%). IIF’s Healthcare exposure has been notably reduced and now stands at 4.9% (down from 6.4% previously). With the top five sectors contributing 79.5% of the overall portfolio (well above key active comparable IFN and passive Indian ETFs), the fund’s fortunes are very closely tied to its sector overweights.

Similarly, the fund’s top ten holdings contribute an outsized ~52% of the portfolio – slightly above key peer IFN but well above most passive alternatives. In line with the financials-heavy sector breakdown, the fund’s single-stock allocation remains skewed toward major Indian banks like ICICI Bank ( IBN ) at 9.9%, Axis Bank (6.0%), and State Bank of India (3.4%). The exclusion of HDFC Bank ( HDB ) is notable, given its outsized presence in the MSCI India Index and IFN. Other notable deviations from the benchmark include a higher weightage for engineering company Larsen & Toubro, which replaces automotive manufacturer Mahindra & Mahindra ( MAHMF ) in the top-five list. IIF’s independent stock selection process is accompanied by uncharacteristic flexibility in managing its cash position, which, per its latest holdings disclosure , has increased to 3.4% (vs. -1.4% last quarter), potentially indicating some profit-taking by the manager.

India Investment Fund Performance – NAV Discount Widens, Defying Strong Performance and Buybacks

After a brief pause in recent months on weather-related concerns, the fund has rebounded on the back of strong fiscal Q2 2024 reporting. As a result, IIF’s one-year total return now stands at +10.4% in NAV terms – well ahead of MSCI India. Zooming out, the fund has compounded well ahead of its benchmark at +9.4% in NAV terms (vs. +7.3% for MSCI India) since its inception in 1994. The annualized three and ten-year returns only reinforce the relative outperformance at +16.4% and +10.2%, respectively. Key closed-end fund comparable IFN hasn’t outperformed MSCI India quite as significantly, yielding +7.8% and +8.3% NAV returns over the last three and five years, respectively.

Where investors have lost out, though, is in IIF’s persistent discount to its underlying NAV, which has further widened in recent months. In contrast, IFN investors, by virtue of the fund’s much faster pace of distributions, have seen IFN's discount close entirely (in some cases, even trade at a premium). Thus far, the IIF manager hasn’t shown quite the same initiative to close the gap, relying on a buyback program and investment performance rather than lowering fees or accelerating distributions. Still, history indicates the NAV discount on this closed-end fund tends to converge around the low to mid-teens, so patient investors could reap a few extra percentage points of outperformance going forward. There’s also more optionality in IIF than IFN - should the manager be pressured into implementing similar investor-friendly policies, IIF’s NAV discount could well mirror the path that IFN has taken this year.

An Unfairly Penalized Active Indian Fund

It’s been a great year for Indian ETFs and an even better one for the abrdn-managed India Fund. The other major US-listed Indian closed-end fund, IIF, on the other hand, has suffered from a widening NAV discount - despite outperforming its benchmark MSCI India index yet again. At the current 19-20%, I’d contend that the discount potentially even cancels out its annual fees – a great deal for a fund with a strong long-term track record and leverage to a compelling multi-year Indian growth story. While I don’t expect IIF’s discount to close completely, a narrower low to mid-teens % discount seems well within reach, given foreign investor flows are returning to India and the ongoing buyback program is gathering pace. Alternatively, a bigger step up in the pace of distributions (a la IFN) would further narrow the discount over time, though this isn’t in my base case right now. Heading into an election year, historically a great time to own Indian stocks, I remain very optimistic about the IIF outlook.

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