A New PIN on India's ETF Map

India has been a hot place to invest in recent years. Yet it's only recently that the country has gotten attention from the exchange-traded fund community.

Last week, PowerShares India Portfolio (NYSE: PIN) became the second pure-play India-focused ETF, after last month's launch of WisdomTree's India Earnings Fund (NYSE: EPI). The PowerShares fund is market-cap weighted, adjusted for foreign fund access, and covers 50 India-listed companies and Indian American depositary receipts). Representing a broad swath of the Indian stock market, the companies in the index have market caps ranging from $3.4 billion to $91 billion.

Quirks of foreign investment in India
While India allows foreign investors to own up to 100% of companies in most industries, the country has limits in some "sensitive" areas. For example, foreigners can hold only a 26% ownership interest in insurance companies. The limit is 49% for passenger airlines. Factoring such quirks into the underlying index can enable an ETF to better represent foreign access to Indian companies.

PowerShares does so using the Indus India Index, based on "IndusCap," a proprietary measure of foreign ownership limits, current foreign holdings, and locked-in stock held by promoters and the government. In contrast, WisdomTree's proprietary India Earnings Index employs an "investable weighting factor" which accounts for both the percentage of free float shares and the foreign investment limit.

Hot stocks in a hot market
Having factored in foreign access, PowerShares ends up with a proprietary twist on a traditional market-cap-weighted index. One risk of the approach is that it may overweight popular stocks, making the fund potentially more volatile in a downturn. Given India's popularity as a leading emerging market and its overall high valuations, these risks are especially evident here.

Furthermore, the fund's IndusCap methodology is untested in current market conditions. While WisdomTree's fund mitigates this risk by focusing more on earnings power, the PowerShares fund seems more susceptible to adverse market conditions.

Concentrated, but cheaper
PowerShares' ETF limits its coverage to just 50 stocks out of the 400 with the largest market capitalization in India. Its top three sectors -- energy, information technology, and financials -- make up over half the portfolio. The top 10 stocks, which include Infosys (Nasdaq: INFY) and HDFC Bank (NYSE: HDB), represent 54% of all holdings. Again, in a highly volatile market like India, this potentially raises risk through undue concentration.

In contrast, Wisdom Tree offers nearly 150 stocks and a slightly lower concentration in its top 10 holdings, which include ICICI Bank (NYSE: IBN) and Sterlite Industries (NYSE: SLT).

But PowerShares' trump card is its lower expense ratio of 0.78% versus WisdomTree's 0.88%. Still, that's a far cry from the expense ratios of broader emerging-market ETFs, such as Vanguard Emerging Markets ETF (AMEX: VWO) and its 0.25% ratio. But for those looking for a pure play on India, those broader ETFs aren't very attractive -- Vanguard's ETF, for instance, has just 8% of its portfolio invested in India.

Is India right for you?
Foreign investors used to the bulldozer governments typical of developing countries will find many aspects of India attractive. In stark contrast to China, it is a vibrant democracy closely scrutinized by a feisty media.

Yet it doesn't come without risks. Its central coalition government depends on the support of parties that are often opposed to reforms and foreign ownership, especially in high-employment sectors like agriculture and retailing. Separately elected state and local governments have their own budgets and agendas. As a result, progress is often two steps forward and one step back. Every initiative must be endlessly negotiated through the labyrinth of central, state, and local politics, with lots of money and favors being traded en route.

Sixty percent of Indians depend on an ailing agriculture sector buffeted by the vagaries of weather, subsidies, and financing. Public sector units such as banks, railways, and airlines are the largest employers and are highly vulnerable to labor unrest. Strong labor laws protect workers and put a burden on large employers. The independent but overloaded legal system moves even slower than traffic on the antediluvian roads. Naturally, major projects can get easily derailed by disputes over property titles, compensation, or parochial politics.

Before investing your money in India, you have to be sure you have the stomach for the pitfalls and obstacles you'll face there. But many believe the potential rewards far outweigh those risks. If that proves to be the case, investors in this new India ETF should do well.

Related Foolishness:

• A Finger on Foreign Investment
• Going Beyond the Index