FLIN - PIN: Easing Is Back On The Menu In India

2023-10-15 10:37:52 ET

Summary

• India's growth engine is chugging along.
• Meanwhile, inflation is trending lower after a brief weather-related shock.
• Investing in the highest-quality Indian large-caps via factor ETFs like PIN continues to be a winning strategy.

The quality emphasis of Invesco's India ETF (PIN) (achieved by tracking the FTSE India Quality and Yield Select Index) has proven to be a winner this year, almost doubling the MSCI India's high-single-digit % gain. While Q3 saw a modest pullback on inflation concerns, this week's headline consumer inflation release (down to +5.0% YoY from +6.8% YoY last month) indicates any pressures should ultimately prove transitory. Core goods and services inflation is also now running below the Reserve Bank of India's (i.e., the Indian central bank or 'RBI') +4% target. Hence, the path is clear for an end to the tightening cycle or potentially even an easing cycle next year (vs consensus expectations for 2025).

Even without a pivot, Indian equities still have plenty to offer on growth (strongest real GDP growth trend in emerging Asia) and returns (best returns on equity in emerging Asia). Valuations aren't cheap, but I'd argue they aren't particularly extended either - PIN investors are currently paying ~20x fwd earnings for a growing portfolio generating >20% ROEs. From a technical perspective, this year's rally hasn't seen too much foreign participation either (at least not as much as you'd expect, given the appeal of the Indian growth story). On balance, I would use any pullbacks in the quality-oriented PIN fund as a buying opportunity ahead of a busy election cycle in the coming months.

A Passive Indian Large-Cap Fund with a Quality Filter

Unlike other large-cap Indian ETFs, the Invesco India ETF differentiates itself by introducing yield and quality (proxied by profitability and leverage metrics) filters, a constraint implemented via the market cap-weighted index it tracks, the FTSE India Quality and Yield Select Index. Its closest comparable is the WisdomTree India Earnings Fund ( EPI ) (see coverage here ), which primarily applies a profitability filter to the Indian large-cap universe. At 0.8%, the fund's expense ratio is at a premium to broad-based Indian large-cap ETFs like the iShares MSCI India ETF ( INDA ) and the Franklin FTSE India ETF (FLIN), though it offers slightly better value than EPI's ~0.9%.

The PIN portfolio's sector exposure has seen some modest changes since my prior coverage - financials remain the largest allocation at 17.9%, followed by information technology (14.6%) and consumer discretionary (the biggest gainer at 12.3%).

The single-stock composition has also been reshuffled slightly, though conglomerate Reliance Industries ( RLNIY ) remains the largest holding at 9.0%. IT services corporation Infosys ( INFY ) has ceded share to HDFC Bank (HDB), which returns to the list post-merger at 6.8%. The portfolio is also slightly larger at 170 holdings, though the re-inclusion of HDB has increased the top five concentration to ~28% of the overall portfolio.

Fund Performance - Betting on Quality Pays Off in India

After a blowout Q2 performance, PIN slowed down in Q3, keeping the YTD total return at a still impressive +11.0% in NAV terms (+10.5% in market price terms). That said, the fund's benchmark FTSE India Quality and Yield Select Index rose by +13.4% over the same period; even after adjusting for the expense ratio, the fund's tracking error is fairly wide. Yet, by Indian factor ETF standards, a 2-3%pt delta isn't unusual, given EPI also runs at similar levels. In contrast, the tracking errors for broad-based Indian ETFs like INDA and FLIN are much narrower in the ~1%pt range YTD.

Zooming out, PIN's track record remains similarly strong - the three and five-year annualized NAV returns stand at +13.9% and +9.5%, respectively. Compared to broad-based India funds like INDA and FLIN, PIN has comfortably outperformed in recent years, highlighting that a factor approach (quality in the case of PIN) to investing in India is the way to go. While key comparable EPI has outperformed PIN (+19.6% and +11.2% annualized over three and five years, respectively), it also comes with less stringent quality and income filters, as well as a pricier fee structure.

Inflation Pressures are Fading Rapidly

After a patchy last few months amid concerns about the monsoon and an emerging El Nino derailing inflation trends, India's latest CPI print has defied these concerns and then some. Per last week's release, consumer inflation is down to +5.0% YoY (vs +6.8% YoY previously), far below consensus expectations and, perhaps more importantly, well within the RBI's policy target range. Digging deeper, food inflation was the key driver, moderating over three percentage points to +6.6% YoY on the back of a sharp pullback in vegetable prices. Beyond the volatile food and energy components, core CPI inflation was also down to +4.5% YoY (+4.8% YoY previously), helped by decelerating inflation in clothing and housing.

India isn't entirely out of the woods yet, given the lingering impact of an uneven monsoon could still pressure food inflation higher in Q4. But the worst is behind us; thus, core inflation looks poised to remain under control at <5% YoY levels through year-end. With overall inflation also trending below the threshold where precautionary tightening would make sense for the RBI, I see a status quo monetary outcome as most likely through year-end. Heading into 2024, YoY inflation will also be lapping a high base and, alongside an external slowdown, could well undershoot. Barring any unforeseen inflationary pressures (e.g., sustained oil price spikes), the RBI should have ample headroom to begin an easing cycle once we move past the elections early next year.

Easing is Back on the Menu in India

India has already outperformed other emerging Asian markets this year, but I don't see the gap narrowing anytime soon. Per this week's data, headline inflation numbers are trending lower after a brief weather-driven supply shock, while the all-important core inflation metric is now back within the RBI's threshold. So, against expectations for some monetary tightening to counter these (short-lived) inflationary pressures, the market now has the all-clear to price in potential easing from lower policy rates (likely next year) and a lower risk premium from India's pending inclusion into major sovereign debt indices .

Indian ETFs like PIN don't come cheap (PIN's portfolio is priced at ~20x earnings), but the superior value creation potential at the upper end of the quality spectrum (sustained >20% ROEs) means investors willing to pay up for the highest-quality large-caps should still come out ahead. With an election catalyst, which typically comes with a timely fiscal boost, looming large, I would use any pullbacks as opportunities to add exposure.

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