Investing internationally has often been the advice given to investors looking to increase the diversification and total return of their portfolio. The diversification benefits are achieved through the addition of low correlation assets of international markets that serve to reduce the overall risk of the portfolio. However, although the benefits of investing internationally are widely accepted theories, many investors are still hesitant to invest abroad. In this article, we'll discuss the reasons why this may be the case and help highlight key concerns for investors so they can make a more informed decision.
TUTORIAL: Risk and Diversification
Likely the biggest barriers to investing in international markets are the transaction costs. Although we live in a relatively globalized and connected world, transactions costs can still vary greatly depending on which foreign market you are investing in. Brokerage commissions are almost always higher in international markets compared to domestic rates. In addition, on top of the higher brokerage commissions, there are frequently additional charges that are piled on top that are specific to the local market, which can include stamp duties, levies, taxes, clearing fees and exchange fees.
As an example, here is a general breakdown of what a single purchase of stock in Hong Kong by a U.S. investor could look like on a per trade basis:
|TOTAL||HK$299 + 0.108%|
In addition, if you are investing through a fund manager or professional manager, you will also see a higher fee structure. To become knowledgeable about a foreign market to the point where the manager can generate good returns, the process involves spending significant amounts of time money on research and analysis. These costs will often include the hiring of analysts and researchers who are familiar with the market, accounting expertise for foreign financial statements, data collection, and other administrative services. For investors, these fees altogether usually end up showing up in the management expense ratio.
One way to minimize transaction costs on buying foreign stock is through the use of American Depository Receipts (ADRs). ADRs trade on local U.S. exchanges and can typically be bought with the same transaction costs as other stocks listed on U.S. exchanges. It should be noted however, that although ADRs are denominated in U.S. dollars, they are still exposed to fluctuations in exchange rates that can significantly affect its value. A depreciating foreign currency relative to the USD will cause the value of the ADR to go down, so some caution is warranted in ADRs. (For more, see An Introduction To Depository Receipts.)
The next area of concern for retail investors is in the area of currency volatility. When investing directly in a foreign market (and not through ADRs), you have to exchange your domestic currency (USD for U.S. investors) into a foreign currency at the current exchange rate in order to purchase the foreign stock. If you then hold the foreign stock for a year and sell it, you will have to convert the foreign currency back into USD at the prevailing exchange rate one year later. It is the uncertainty of what the future exchange rate will be that scares many investors. Also, since a significant part of your foreign stock return will be affected by the currency return, investors investing internationally should eliminate this risk.
The solution to mitigating this currency risk, as any financial professional will likely tell you, is to simply hedge your currency exposure. However, not many retail investors know how to hedge currency risk and which products to use. There are tools such as currency futures, options, and forwards that can be used to hedge this risk, but these instruments are usually too complex for a normal investor. Alternatively, one tool to hedge currency exposure that may be more "user-friendly" for the average investor is the currency ETF. This is due to their good liquidity, accessibility and relative simplicity. (If you want to learn the mechanics of hedging with a currency ETF, see Hedge Against Exchange Rate Risk With Currency ETFs.)
Another risk inherent in foreign markets, especially in emerging markets, is liquidity risk. Liquidity risk is the risk of not being able to sell your stock quickly enough once a sell order is entered. In the previous discussion on currency risk we described how currency risks can be eliminated, however there is typically no way for the average investor to protect themselves from liquidity risk. Therefore, investors should pay particular attention to foreign investments that are, or can become, illiquid by the time they want to close their position.
Further, there are some common ways to evaluate the liquidity of an asset before purchase. One method is to simply observe the bid-ask spread of the asset over time. Illiquid assets will have wider bid-ask spread relative to other assets. Narrower spreads and high volume typically point to higher liquidity. Altogether, these basic measures can help you create a picture of an asset's liquidity.
Investing in international stocks is often a great way to diversify your portfolio and get potentially higher returns. However, for the average investor, navigating the international markets can be a difficult task that can be fraught with challenges. By understanding some of the main risks and barriers faced in international markets, an investor can position themselves to minimize these risks. Lastly, investors face more than just these three risks when investing abroad, but knowing these key ones will start you off on a strong footing. (For additional reading, also check out Going International.)