Dow Jones

Mumbai

India’s stock market is enjoying a moment in the sun. But investors shouldn’t be blinded to the risks by this year’s shimmering returns.

The economy of the world’s largest democracy is rebounding as a new government pursues overhauls aimed at boosting exports and reducing bureaucratic hurdles. The International Monetary Fund is projecting growth of 5.4% this year for India and 6.4% next year.

Investors have taken notice, bidding up share prices and helping the Indian stock market outpace the US and many other developed and emerging markets this year. The benchmark S&P BSE Sensex Index is up 28% in 2014, through Thursday.  The rally has helped turn India into a darling of US investors looking for the next hot emerging market.

Investors have poured $1.9bn into the 10 largest US exchange-traded funds that focus on Indian stocks this year, as of September 12, up from $325mn in 2013, according to Chicago-based investment researcher Morningstar.

“India is much better positioned than most emerging markets. Their long-term outlook is positive,” says Neena Mishra, director of ETF research at Zacks Investment Research, which is also based in Chicago and which provides information and analysis to investors.

Among the reasons, according to Mishra, a former official at India’s central bank: India’s recently elected prime minister, Narendra Modi, is “focused on slow, steady growth”; the nation’s banks are getting stronger; and domestic consumers are fuelling economic growth.  Yet there are reasons why even bullish US investors should approach India with caution.  Investors may be tempted to compare India with China, another large country that is unleashing its economic potential. But India isn’t pursuing the same kind of strategy of rapid industrialisation and urbanisation that China has for years.

Investors have also become more jittery about emerging markets in recent weeks, amid concerns that returns could be undercut when the US Federal Reserve moves to raise interest rates.

India’s growth has come in fits and starts, and Indian stocks have seen sharp swings in recent years. For example, India’s benchmark index generated an 83% return for investors in 2009, including dividends, compared with a 26% gain in the S&P 500 in the US, then dropped 27% in 2011, when the S&P 500 gained 2%.  Over the past five years, the S&P BSE Sensex has gained 67%, through Thursday, according to FactSet. By comparison, the S&P 500 has gained 109%.

“Single-country investing in emerging markets is risky,” says Patricia Oey, a Morningstar analyst. “For most retail investors, it makes more sense to invest in a diversified emerging-markets fund that holds securities from different countries.”  If you choose to take the risk, make sure you spread your bets around in other emerging markets as well, so that you won’t get pummelled if India’s market turns south.

You should also limit your bets on emerging markets overall. They should comprise no more than 5% of the stock portfolio of an investor whose aim is to generate moderate growth, advisers recommend.  One way to invest in India is through an ETF or mutual fund that holds a broad basket of Indian stocks. The two largest India-focused ETFs by assets are the WisdomTree India Earnings ETF, which charges annual fees of 0.83%, or $83 for every $10,000 invested, and the iShares MSCI India ETF, which charges annual fees of 0.67%.

The two funds both bet on large Indian firms and hold many of the same stocks. The top five holdings in each ETF include Reliance Industries, an energy conglomerate, and Infosys, an information technology firm, for example. The WisdomTree fund is up 34% this year, through Thursday, while the iShares fund is up 28%.  Another alternative is the Market Vectors India Small-Cap Index ETF, which invests in small, lesser-known firms that stand to benefit from any growth in domestic Indian demand. The fund is up 56% this year. Its 0.93% annual fee is higher than the two largest funds, and the size of the companies it invests in could expose investors to more volatile swings.

Mutual funds that invest in India are another option, but they tend to be more expensive, in some cases charging twice as much or more as the largest ETFs. One of the least-expensive India-focused mutual funds is the Matthews India Fund, which charges 1.13% and has gained 54% this year.