Investors who want to increase the diversification and total return of their portfolios are often advised to get into international assets. Many hesitate to take that advice.
There are, in fact, three big risks that investors add when they enter international investing. Knowing what they are and how you can mitigate those risks may help you decide if going global is worth the risk and potential rewards.
1. Higher Transaction Costs
The biggest barrier to investing in international markets is the added transaction cost. Yes, we live in a relatively globalized and connected world, but transaction costs still vary greatly depending on which foreign market you are investing in. Brokerage commissions in international markets are almost always higher than U.S. rates.
- Expenses on foreign transactions tend to be substantially higher.
- Currency volatility is an additional layer of risk in making foreign transactions.
- Liquidity can be a problem, especially when investing in emerging economies.
On top of the higher brokerage commissions, there can be additional charges specific to the local market. These 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%|
That's about $38.60 U.S. in fees per trade, based on the exchange rate on Aug. 1, 2020.
In addition, if you are investing through a fund manager or professional manager, the fee structure will be higher than usual.
For the manager, the process of recommending international investments involves significant amounts of time and money spent on research and analysis. The may include hiring analysts and researchers who are familiar with the market, and other professionals with expertise in foreign financial statements, data collection, and other administrative services.
Investing in American Depository Receipts (ADRs) is an option for those who want to avoid the higher fees of foreign asset purchases.
For investors, these fees will show up in the management expense ratio.
One way to minimize transaction costs on international stocks is by investing in American depositary receipts (ADRs). Depositary receipts, like stocks, are negotiable financial instruments but they are issued by U.S. banks. They represent a foreign company's stock but trade as a U.S. stock, eliminating the foreign exchange fees.
ADRs are sold in U.S. dollars. And that makes their investors vulnerable to currency price fluctuations. That is, if you buy an ADR in a German company, and the U.S. dollar falls in value against the euro, the value of the ADR will drop correspondingly. Of course, it works both ways, but the risk is there.
2. Currency Volatility
When investing directly in a foreign market (and not through ADRs), you first have to exchange your U.S. dollars into a foreign currency at the current exchange rate.
Say you hold the foreign stock for a year and then sell it. That means you will have to convert the foreign currency back into USD. That could help or hurt your return, depending on which way the dollar is moving.
It is this uncertainty that scares off many investors.
A financial professional would tell you that the solution to mitigating currency risk is to simply hedge your currency exposure. The available tools include currency futures, options, and forwards. These are not strategies most individual investors would be comfortable using.
A more user-friendly version of those tools is the currency exchange-traded fund (ETF). Like any ETF, these have good liquidity and accessibility and are relatively straightforward.
3. Liquidity Risks
Another risk inherent in foreign markets, especially in emerging markets, is liquidity risk. This is the risk of not being able to sell an investment quickly at any time without risking substantial losses due to a political or economic crisis.
There is no easy way for the average investor to protect against liquidity risk in foreign markets. Investors must pay particular attention to foreign investments that are or may become illiquid by the time they want to sell.
There are some common ways to evaluate the liquidity of an asset. One method is to observe the bid-ask spread of the asset over time. An illiquid asset will have a wider bid-ask spread relative to other assets. Narrower spreads and high volume typically point to higher liquidity.
Stock Exchange of Hong Kong (HKEX). "Transaction."
U.S. Securities & Exchange Commission. "American Depositary Receipts."