One of the primary reasons for international investing's popularity can be summed up in one word: diversification. Foreign markets provide access to a considerable number of investment opportunities, such as emerging markets and specialized regional economies. In fact, although the United States is the world's largest stock market, almost 50% of the world's stock market investing opportunities are located outside of U.S. borders, according to the MSCI All Country World Index, a commonly cited measure of the world's stock market composition. To participate in the global marketplace, many investors choose mutual funds. Here we look at the major fund categories that exist for investors seeking international opportunities, as well as the advantages and disadvantages of these funds.

Mutual Fund Varieties
You can access a wide variety of international investments through mutual funds. There are money market funds, funds that specialize in stocks, funds that specialize in bonds and funds that build portfolios by combining stocks and bonds.

The major fund categories for investors seeking exposure to foreign markets include the following:

  • Global Funds
    Global funds seek opportunities worldwide, although many global fund managers invest the bulk of their assets in U.S. markets.
  • International Funds
    International funds invest strictly in non-U.S. markets. They achieve diversification by investing in both established markets and developing economies. Developing economies, popularly known as "emerging markets," can offer significantly greater growth opportunities than those available in established markets.
  • Regional Funds
    Regional funds focus on specific geographical regions, such as Europe or Asia. These funds achieve diversification by investing in multiple countries in a given region.
  • Country Funds
    Country funds concentrate on building a portfolio of securities issued by a single country. Germany, Japan and Mexico are each the focus of numerous country funds.

Active and Passive Management
Whether you prefer an actively managed fund or one that's passively managed, you can find a fund with exposure to foreign markets that suits your style. Investors seeking active management often turn to mutual funds for the quality research that an experienced fund management team can provide when it comes to seeking opportunities in markets such as Turkey, China and Japan.

Passive investors can choose from a wide variety of index funds, including funds in each of the major categories, as well as a variety of funds that focus on specialty areas such as natural resources and socially-responsible investing.

The Risks of International Investing
International and domestic mutual funds share certain risks. Stock funds are subject to declining market values. Bond funds may be negatively affected by interest rate changes or by the inability of a creditor to repay a loan. Whether the fund in question is domestic or international, investors risk losing some or all of their initial investment.

However, investing in international securities carries an additional set of risks not usually seen in domestic investments. Investors need to be aware of the many issues that can impact the value of their investments, including currency risk, political/economic/social risk, lack of market supervision and information, lack of liquidity and higher costs.

Currency Risk
Because foreign firms generally pay dividends and capital gains in their local currencies, currency risk is a primary concern. When a particular foreign currency is stronger than an investor's home currency, the investor benefits by receiving more of his or her home currency in return for each unit of foreign currency when converting. Using fictional exchange rates, for example, let's assume a U.S. investor uses US$10,000 to purchase a British pounds investment in some securities in the U.K. At that time, £1 = US$2 (conversely, US$1 = £0.50). The investor's US$10,000 would be worth £5,000 of the U.K. securities. When the investor sells the U.K. securities, the pound has appreciated, or become "stronger," vis-a-vis the U.S. dollar. The exchange rate is now £1 = US$2.50 (conversely, US$1 = £0.40). So, the lucky U.S. investor converts £5,000 into US$12,500 ( £5,000*2.5).

The opposite is true when the home currency is stronger than a given foreign currency. A weak foreign currency reduces the amount of money investors receive when the foreign currency is converted. While a weak foreign currency is great news for travelers heading overseas, it can be of significant concern from their home country position as an investor in overseas securities.

Given these realities, you should consider the exchange rate outlook for your domestic currency and your host foreign country's currency before investing in a foreign mutual fund. If you make a sizable investment in a foreign mutual fund and your domestic currency subsequently appreciates significantly against the foreign currency, even strong domestic returns of your foreign mutual fund can be eroded into mediocre gains or even losses once the effects of currency conversion are realized.

Some mutual funds hedge their foreign exchange risks, in which case both the potential risks and rewards from unhedged foreign currency risks are neutralized. Investors should be sure to understand a fund's management position in this regard.

Political/Economic/Social Risk
Many countries experience significant social and political upheaval. Military coups, war, civilian unrest, terrorist activity and other unexpected events can have negative consequences for investors. High returns will be of very little use to you if a foreign government decides to impose new taxes on withdrawals of cash outside its borders, or worse, appropriates your previously successful corporation (and its profits) into the government's coffers.

Regulatory Considerations
Many foreign countries do not have the same supervision and control standards as those in the U.S. Full financial disclosure and corporate governance vary greatly. This can make it difficult to obtain the type of information necessary to properly analyze a firm, country or region's economic health. Even if adequate information can be obtained, it may prove costly and time consuming for fund managers to obtain, and those information costs will eat into their returns at the end of the day.

Lack of Liquidity
Not all foreign markets offer a highly developed marketplace that enables nearly instantaneous trading of a large volume of individual securities. This can make it difficult to trade securities in a quick, convenient manner. As such, you need to consider your investment time horizon and your chosen foreign market's liquidity level, and make sure there are no obvious potential conflicts between the two.

Higher Costs
Investing in international markets can be more expensive due to a variety of taxes, transaction costs and commissions. As a result, mutual funds that invest in international markets tend to have higher expense ratios than similar domestic funds. Keep these costs in mind when considering international mutual funds, as their performance needs to more than compensate for their added expense to be of value to you.

The Appeal of Mutual Funds
Mutual funds are a convenient way to invest in international markets. Investing in international funds adds diversification to your portfolio, provides an opportunity to participate in the growth opportunities in foreign markets, and delegates responsibility for addressing most of the risks to professional money managers.

With an actively managed mutual fund, money managers and analysts conduct research on potential holdings. In an index fund, the managers and analysts monitor the benchmark index and adjust their portfolio holdings to make sure they match the index as companies are added and removed from the benchmark.

In an actively managed portfolio, the money manager will also bear the burden of worrying about the political, economic and social risks. Nor do you need to be concerned about liquidity risk because the mutual fund company will redeem your shares, with no need for you to find a buyer on the open market. Although it's true that each of the risks we've discussed may still impact your portfolio's value, the day-to-day task of trying to mitigate the risks can be delegated to the experts.

The Bottom Line
While international funds offer the potential for significant rewards, they do have their risks. Professional financial advisors rarely recommend that international investments account for more than a minority share of an investor's portfolio. Investors often overlook the fact that their domestic funds may well have a significant percentage of their portfolios invested in foreign securities. These positions should be checked before you load up on additional foreign exposure through international funds.

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