American market players get to choose from nearly 8000 stocks listed on NYSE and Nasdaq, as well as thousands of other securities traded over the counter (OTC) or available through private placements. Even with all this variety, foreign markets hold a special attraction because they add specific categories of risk not available locally. In addition, the modern 24 hour marketplace has shifted the focus of US participants to economic events all over the world that move both our local equities and investment scenarios in other regions. (For more, read: Evaluating Country Risk For International Investing).
Many foreign market have the added benefit of sidestepping correlated price action between asset classes when macro forces hit the market. For example, a Federal Reserve policy change could trigger shock waves worldwide, but some emerging markets will ignore the news, continuing instead to trade on local events. These "independent" bourses provide safe haven to sophisticated traders and investors, especially when used in allocation strategies that seek diversification from US market forces. (For related reading, see: Safe Havens In Foreign Currency ETFs).
Modern markets provide four ways to build foreign exposure: buy American Depository Receipts (ADRs) on US exchanges, buy country funds listed on US exchanges, obtain access to foreign equities through a US broker or open a brokerage account in the country you want to trade. The last solution isn’t worth the effort in most cases because the few countries that restrict international access to local exchanges, including China, are slowly coming around with more convenient avenues to foreign investment. (See also: The 3 Biggest Risks Faced By International Investors).
Let’s look at the advantages and pitfalls of the most popular ways to buy and sell foreign securities, with an eye toward gaining exposure at the lowest transaction cost. As you’ll see, cost becomes a major factor in choosing the best path of execution because many foreign markets charge far more for access than US securities. This is even true for ADRs, so we’ll look at those locally-traded instruments first.
American Depository Receipts (ADRs)
Hundreds of foreign companies list their stocks in the United States through ADRs, with many providing high liquidity access to non-US exposure. ADRs typically charge custodial fees of .01 to .03 per share, paid by US brokers to the agent banks. Until 2009, these fees were taken from dividends, making them less obvious to the typical investor. New rules expanded the collection into non-dividend paying securities, with brokers now collecting those fees directly from the client. (To learn more, read: Investing in Foreign Stocks: ADRs and GDRs).
In addition to trading and investment, ADRs provide a lower cost method to short sell foreign securities. The practice is illegal in many foreign exchanges while other venues maintain burdensome rules, enforced by high fees and borrowing costs. Many ADRs dodge these restrictions, allowing free access to the sell side. Costs are higher due to fees and currency conversion, but the advantages outweigh the added costs. This access is especially valuable when the US dollar is trading higher, often reflecting weakness in other currencies and markets.
Top 10 ADRs by volume:
US exchanges currently list 44 country ETFs or ETNs, which have characteristics of ETFs and bonds (See: ETF Or ETN? What's The Difference?). Fund action tracks indices in the chosen country after subtracting fees that are typically higher than other ETF categories. A popular strategy buys a basket of country funds, reallocating at regular intervals to capture greater returns. They also work extremely well when making country-specific bets, like shorting Global X FTSE Greece 20 ETF (GREK) when high debt levels threatened its membership in the European Union.
Country baskets work great in building foreign exposure but carry obvious risks. First, the strategy backfires if too much capital finds its way into non-performing funds while missing opportunities in other countries. Second, returns suffer when reallocations are made too frequently because of increased transaction costs. These pitfalls suggest that the best basket strategies limit allocations to relatively few funds that act as proxies for other countries with similar economic, social and political issues.
Top 10 country funds by volume:
If ADRs and country funds don’t satisfy your appetite for foreign exposure, you can trade those markets directly without opening a new brokerage account, but be prepared to pay a hefty premium. (See: How To Trade International Stocks). Major US brokers, like Fidelity Investments, Chas Schwab and Interactive Brokers now provide access to dozens of these markets through global accounts. While it’s easy to buy, sell and track foreign securities through these platforms, the fine print can cause a lot of confusion.
For example, a 1000 share buy order for France’s CAC 40 blue chip Airbus Group (AIR.PA) costs €19 at Fidelity and Schwab, or around $21.00 as of March 1, 2015 when it was trading near €56, while Interactive Brokers' charges 0.1% of the trade’s value up to a €29 maximum, which gets hit above 600 shares on that security. In addition, the trader must incur a French financial transaction tax of .02% or another €11.28.
Foreign transactions may incur additional costs, including stamp duties, transaction levies and trading fees. They’re also vulnerable to currency fluctuations, especially in volatile markets, adding another roadblock to profitable positioning. US brokers complicate the cost-benefit analysis further by tacking on currency conversion fees when the transaction is made in Euros, Yen and other foreign currencies. (Learn more by reading: Protect Your Foreign Investments From Currency Risk).
While US brokers provide rudimentary charting for foreign securities, most buyers will need more sophisticated technical analysis, forcing them to add foreign coverage to already expensive real-time programs. Single exchange access for European bourses now ranges between $1 and $60 per month at eSignal, a popular data provider. (Fore more, see: The Best Technical Analysis Trading Software). While package pricing is available, adding all major continental exchanges will add significant costs, especially when additional services like market depth are required for more sophisticated strategies.
The Bottom Line
Foreign securities let traders and investors diversify their exposure, while lowering the risk of macro events that force thousands of financial instruments into lockstep behavior. Access to foreign markets has grown a lot in recent years, allowing US market players to trade these bourses in real-time. While higher transaction costs add a real hurdle to profitability, there are strategies that show great potential in building excellent long-term returns.