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Morningstar data on eight India ETFs show that tracking differences varied widely between the funds in each of the past three years but there was also a wide variation from year to year for all the funds.Danish Siddiqui/Reuters

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Emerging-market funds have just enjoyed their largest monthly inflows in almost two years, but some markets, such as India, have structural issues that can eat into returns on equity investments.

International investors owning local Indian stocks are subject to taxation on capital gains at a rate of 15 per cent for positions held for less than one year and 10 per cent on longer-term holdings, says Dina Ting, head of global index portfolio management at Franklin Templeton Investments, whose Franklin FTSE India UCITS ETF underperformed its benchmark FTSE India 30/18 Capped Index by 4.05 percentage points in 2020, the year after its launch in 2019.

“This should be seen as an unavoidable cost and risk of investing in India,” Ms. Ting adds.

An emerging-market specialist at a large investment bank echoed that sentiment.

“India does potentially put itself at a disadvantage versus other emerging markets in this respect,” says the specialist, who did not want to be identified.

“When you look at active India funds, the ETF [exchange-traded fund] is actually a better benchmark rather than say an MSCI index because the index is gross of capital gains tax – a reality no international investor has,” he adds.

Divergence from the underlying index is not unique to Franklin FTSE India UCITS ETF; iShares India ETF XID-T underperformed its benchmark Nifty 50 index in 2021 by an even wider margin of more than 5 percentage points, Morningstar Inc. data show.

The Franklin ETF’s tracking difference – the difference between the return of the ETF and that of its underlying index – remained at a steep minus 3.88 percentage points in 2021. However, in 2022, when the index fell 8.36 per cent, the tracking difference turned positive, with the ETF outperforming its benchmark by 0.47 percentage points.

“Franklin ETFs accrue capital gains tax in the [net asset value (NAV) of the fund] on a daily basis,” Ms. Ting explains.

“In rising markets, we will see the fund typically underperform its benchmark and vice versa, provided the current market value of the fund holdings is above their historical book cost,” she adds.

Kenneth Lamont, senior fund analyst for passive strategies at Morningstar Inc., says it was often assumed that a passive fund will lag its index by its combined management fee and running costs.

But, “in the case of markets which are more difficult to access, tracking difference becomes even more important,” Mr. Lamont says. “Barriers to investment such as taxes or trading fees can see costs spiral and tracking differences balloon – in some cases, like India, dwarfing the impact of management fees.”

Ms. Ting says the impact of capital gains tax on a fund’s valuation was not only unavoidable but also heavily influenced by the timing and volume of purchases and sales.

“Franklin Templeton’s tax process was selected for its transparency benefits, given that unrealized capital gains tax is included in daily NAV calculations,” she adds.

Morningstar data on eight India ETFs show that tracking differences varied widely between the funds in each of the past three years but there was also a wide variation from year to year for all the funds.

“Funds, including ETFs, generally may account for the tax in different ways and performance data is not directly comparable,” Ms. Ting says.

Taxation considerations can also apply to other markets, for example, overseas investors in U.S. equity ETFs. When a U.S. company pays a dividend to a non-US citizen, a 30 per cent tax rate can apply, depending on the jurisdiction.

© The Financial Times Limited 2023. All Rights Reserved. FT and Financial Times are trademarks of the Financial Times Ltd. Not to be redistributed, copied, or modified in any way.

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