As Infosys Slides, Small-Cap ETFs May be Better Indian Bet

Using the WisdomTree India Earnings ETF (NYSE:EPI) as the measuring stick, India has been the top performer among the BRIC quartet in 2012. Even with a 2.3 percent tumble on Friday, EPI's 20.8 percent year-to-date gain is nearly twice as good as the comparable Russia ETF. EPI has also delivered about 870 basis points more alpha than the largest China ETF. Forget Brazil, because the iShares MSCI Brazil Index Fund (NSYE: EWZ) is down on the year.

The bullish performance of EPI and its counterparts belies the fact that 2012 has been a tumultuous one for Indian stocks. Amid slowing growth, major infrastructure problems and a government accused of not caring much about either issue, India was at risk of losing its tenuous investment-grade credit rating. That prompted significant slides in India ETFs during the second quarter.

Fortunately for investors, India's government moved to bolster the economy in the third quarter with policy measures including reduced diesel subsidies and looser rules on foreign ownership in the retail sector.

Indeed, it has been an up-and-down year for Indian equities and some of the corresponding U.S.-listed ETFs. Now, a new issue has entered the picture. That being the slack performance of Indian information technology firm Infosys (NASDAQ:INFY).

Shares of Infosys have plunged 13.5 percent in the past three months, with much of those declines attributable to the company's plan to shift to more of a consulting outfit away from outsourcing, as Barron's recently reported. That would put Infosys in direct competition with the likes of Accenture (NYSE:ACN) and International Business Machines (NYSE:IBM).

The problem for India ETFs is that information technology is usually a significant sector weight in the large-cap funds and Infosys is often a top-10 holdings in these ETFs. Infosys is EPI's third-largest holding with a weight of 5.42 percent. The PowerShares India Portfolio (NYSE:PIN) devotes 9.4 percent to the stock.

Infosys represents almost six percent of the iShares S&P India Nifty 50 Index Fund's (NASDAQ:INDY) weight and more than seven percent of the iShares MSCI India Index Fund (BATS: INDA). Those weights are not large enough to completely wreck these ETFs (EPI and INDY are slightly higher over the past 90 days), but the Infosys allocations are just enough to be near-term problematic.

The solution for investors looking to stay in the Indian ETF game while dodging Infosys for the time being is easy to spot. That objective can be accomplished with small-cap ETFs. There are three ETFs devoted exclusively to Indian small-caps: The EGShares India Small ETF (NYSE:SCIN), the Market Vectors India Small-Cap ETF (NYSE:SCIF) and the new iShares MSCI India Small Cap Index Fund (BATS: SMIN).

Over the past 90 days, SMIN has surged 7.4 percent while the average returns offered by SCIF and SCIN are about 4.5 percent. None of these ETFs are heavily exposed to tech stocks and since Infosys is a large-cap, it is barred from entry to these fund.

All are heavy on financials with SMIN devoting almost 28 percent of its weight to the sector. SCIN checks in with an almost 24 percent weight to bank stocks. The real story with India small-cap ETFs, beyond the obvious advantage of not being home to Infosys, is the exposure to the consumer these ETFs offer.

To this point in 2012, the EGShares India Consumer ETF (NYSE:INCO) is far and away the top-performing India ETF with a gain of 51 percent. That performance indicates some investors are feeling good about the potential of the Indian consumer, but others have a tendency to overlook INCO because of its size and low trading volume.

The aforementioned India small-cap ETFs stand as suitable alternatives because all are highly levered to the Indian consumer. Over 21 percent of SCIN's sector allocations are direct plays on the consumer. SCIF is in the area of 20 percent while a combined 23.7 percent of SMIN's weight goes to discretionary and staples names.

The bottom line is that if the Indian consumer proves resilient in 2013, Infosys will have little or no bearing on SCIF, SCIN and SMIN. And that could be a good thing.

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