As Rupee Heads To 70, India ETFs Feel The Pain

There is an easy to put into context the impact India's plunging rupee has had on the country's equities and the ETFs that house them. And it goes beyond the fact that $1 now buys about 65 rupees, up from around 55 rupees at the end of last year.

Chew on this tidbit: There are eleven India ETFs trading in the U.S. Excluding the recently reverse split Direxion Daily 3X India Shares (NYSE:INDL), six of the remaining 10 India ETFs are among the 10 worst-performing non-leveraged ETFs of any stripe over the past month.

The four largest ETFs, a group that includes the iPath MSCI India ETN (NYSE:INP), are down an average of 25.2 percent year-to-date. At the ETF level, the makes India the worst performer among the major funds tracking the BRIC nations. An average loss of 25.2 percent is worst than 24.8 percent decline for the iShares MSCI Brazil Capped ETF (NYSE:EWZ) and more than twice as worse as the loss incurred by iShares China Large-Cap ETF (NYSE:FXI).

Back to the rupee. It trades at 64.45 at this writing. The pain is unlikely to stop there or at 65. There is a fair chance $1 will buy 70 rupees and do so sometime in a matter of weeks. One significant problem for Indian assets is that currencies can overshoot to a point of being undervalued, but remain that way for a long a time.

"However, just as in equities, cheap' valuations can become even cheaper; during periods of market stress. Indeed, the most recent period has been particularly difficult, as many investors have shunned nearly all emerging market assets in 2013," said WisdomTree Portfolio Manager Rick Harper in a note. "Absent investment flows, increases in economic growth or a general change in sentiment, foreign currencies and asset prices have remained weak against a domestic equity market that has recently touched all-time highs."

At the end of July, the rupee's purchasing power parity was discounted to the tune of 63 percent, according to WisdomTree data. Another way of looking at that scenario is that if two currencies, say the U.S. dollar and Australian dollar, are in equilibrium, a trip to Starbucks should cost relatively the same in Sydney after greenbacks are converted to the Aussie as the same trip to a Starbucks in Dallas.

The weak currency has put the Reserve Bank of India between a rock and a hard place. Since late 2011, RBI has lowered rates four times, but now that it needs to boost rates to stem rupee outflows, it cannot because economic growth in Asia's third-largest economy is slowing.

At the ETF level, the weak rupee causes problems. Clearly. And the situation will get worse at 70 to a dollar. The problem comes by way of sector distribution within these funds. That does not mean India ETFs are poorly constructed. They are not. At the sector level, however, only two groups technology and health care truly benefit from rupee weakness.

Indian pharma companies are big exporters, so the weak rupee helps them. Operating margins for Indian technology exporters tend to rise 30 to 35 basis when the rupee falls 1% against the dollar, but Indian energy, industrial, telecom and utilities companies are all vulnerable to a weak rupee.

The largest India ETF has a 21.6 percent combined weight to technology and health care. However, a rival product has an almost 20 percent weight to the sectors most vulnerable to rupee weakness and comparable weights to those groups are seen across rival funds.

India ETFs are locked in a race to the "BRIC bottom" with their Brazilian counterparts. In an interesting twist of fate, Brazil's government, like India', has hindered not helped economic progress. Central banks and policymakers in both countries have proven less than adept at dealing with slowing growth and faltering currencies.

Predictably, this damages investors' confidence and prompts outflows from rupee-denominated assets, further weakening the currency. And that explains why one marquee India ETF is trading near its lowest levels since 2009 and another is touched an all-time low earlier this week.

For more on ETFs, click here.

Disclosure: Author owns none of the securities mentioned here.