Today, opportunities are not bound by geographies. Investing in foreign stocks means holding shares of companies that are not only based in different geographical locations, they are also driven by the respective economy-specific factors. Thus investing in foreign stocks spreads the investment risk among international markets that are different from the home economy.
Those who invest internationally look to gain from diversification and growth in other economies. This factor is particularly relevant since no particular market has consistently remained on the top, and there is a wide range of high-performance markets all over the world. Though the correlation between stock markets across the globe has increased over the years, there is variation in the degree of movement. (Read more about whether the stock correlation strategy is effective.)
Like most things, international investing has its flip side. When measured in terms of volatility, foreign stocks are considered to be riskier. Other than the fact that foreign stocks tend to experience dramatic changes in their market value, these stocks have other risks attached to them. First is the political risk that arises from an unstable government or military action in the country of investment. The second factor is that the majority of the global markets are less regulated than developed markets like those in the US, increasing the risk of manipulation or fraud.
There is also a risk due to inadequate reliable information available about various international markets, which can limit the investor’s precision of market movement. Even in cases where adequate information is available, the right interpretation of it can be challenging for an outside investor.
Finally, there is currency risk, which stems from potential unfavorable movements against the home currency. However, currency movement can also work in favor of the investor and help in enhancing the returns. Other than the risks, investors must calculate the costs involved in the process. These are usually in the form of fees, commissions, and taxes.
Overall, foreign stocks offer a great opportunity, given the benefit of geographical diversification and exposure to multiple growing economies. Most financial experts and advisors consider foreign stocks healthy for an investor’s portfolio and recommend an allocation of 5-10 percent for conservative investors to a maximum of 25 percent for aggressive investors.
For investors who understand the opportunity and risk of international investing well, there are many ways to gain exposure to foreign stocks. The popular ways to trade foreign stocks are listed below:
1. American Depositary Receipt (ADR)
American Depositary Receipts, popularly known as ADRs, work well for investors, as well as for non-US companies. ADRs offer investors a convenient way to hold foreign stocks and also provide an opportunity to non-US companies to establish a US presence and even raise capital in the US stock markets. The world’s largest IPO, Alibaba Group Holding Limited (BABA), is an example of a Chinese giant raising capital via an IPO and trading in the US as an ADR.
The ADRs can be sponsored or unsponsored and have three different levels, depending upon foreign companies’ access to US markets, as well as disclosure and compliance requirements. Level 1 ADRs cannot be used to raise capital and are only traded over-the-counter. While Level 2 and Level 3 ADRs are both listed on an established stock exchange (NYSE, AMEX, or NASDAQ), only Level 3 ADRs can be used to raise capital.
In order to equate its price in the home and issuer country, each ADR represents the underlying shares in a different ratio, as it may represent a fraction (in case of expensive shares), one, or more shares of the foreign stock. For example, each Vodafone Group plc ADR (VOD) represents 10 ordinary shares, while Japan’s Sony Corporation has a 1:1 ratio (SNE). Since these companies are listed, traded, and settled like US shares, it is a convenient way for the average investor to hold foreign stocks. However, investors must inquire about the fees charged by the broker-dealer. (For more, read American Depository Receipts Basics.)
2. Global Depository Receipts
Global Depository Receipts or GDRs are a category of depository receipts like ADRs. With GDRs, a depository bank issues shares of foreign companies in international markets (typically in Europe) and are available to investors within and outside the US, giving them an opportunity to invest in foreign stocks. At the same time, the issuing companies get access to global markets and investors. While GDRs are mostly denominated in US dollars (sometimes in euro’s or sterling), they are typically traded, cleared, and settled in the same way as domestic stocks.
The London and Luxembourg Stock Exchanges are the most common destination for the listing of GDRs. In addition, they have also been listed on exchanges in Singapore, Frankfurt, and Dubai. Other than two exceptions, the first for non-US investors (Regulation S) and the second for US investors who qualify as Qualified Institutional Buyers (Rule 144A), GDRs are offered to institutional investors via a private offering. (Read more about investing in foreign stocks.)
3. Direct Investing
There are two ways by which investors can invest directly in foreign stocks. The first is by opening a global account with a broker in their home country, providing the ability to buy foreign stocks (like Fidelity, E*TRADE, Charles Schwab, or Interactive Brokers in the US), while the other is to open an account with a local broker in the target country that offers services to international investors (like the Boom’s Trading Platform in Hong Kong or OCBC Securities in Singapore, which give access to not only the local market but other stock markets).
Investors need to pick the right trading platform based on their investing style and interest in addition to factors such as fees, costs, and facilities provided by the brokerage firm. However, going direct is not suited for small or casual investors as the system is complicated, involving costs, taxation issues, technical support, currency conversions, research, and more. Given all this, only active and serious investors should indulge in the process. Investors also need to be wary of any fraudulent brokers who are not registered with the market regulator in the home country, like the Securities and Exchange Commission (SEC) in the US.
4. Mutual Funds
Investors who are keen on exploring the international markets without much hassle can opt to invest in international mutual funds. These funds are like regular mutual funds in terms of the benefits they offer and how they work, except they hold a portfolio of foreign stocks rather than domestic stocks. These funds come in a variety of flavors with something for everyone, from aggressive to conservative investors. The main kinds of funds that invest in foreign funds are global funds, international funds, region- or country-specific funds, and international index funds. Like other international investments, these funds tend to be costlier than domestic counterparts.
5. Exchange-Traded Funds
International exchange-traded funds offer an easy and convenient way for investors to access the foreign markets. Picking the right exchange-traded funds (ETFs) is easier for investors than constructing a portfolio of stocks by themselves. While a single ETF can offer a way to invest globally, there are ETFs that offer more concentrated bets, such as on a particular country.
There is a wide range of international ETFs within different categories like market capitalization, geographical region, investment style, and sectors. The prominent ETFs come from providers like iShares, SPDR, Vanguard, FlexShares, Schwab, Direxion, First Trust, Guggenheim, PowerShares, WisdomTree, and Market Vectors, among others. Investors should research the costs, liquidity, fees, trading volume, taxation, and portfolio before buying any international ETFs.
6. Multinational Corporations
Investors who are not comfortable buying foreign stocks directly and are even vary of ADRs or mutual funds can look for domestic companies that have a majority of their sales and revenue overseas. The best-suited companies for the purpose would be multinational corporations (MNCs). For a US investor, it could be shares of MNCs like the Coca-Cola Company (KO) or the McDonald's Corporation (MCD), companies that generate a bulk of their revenue from global operations. This approach is more like a back door entry and does not provide true international diversification.
The Bottom Line
Regardless of the route chosen to invest in foreign stocks, investors should learn about the product they are investing in, which can be stocks (in the case of direct investing or ADRs), international mutual funds, or ETFs. In addition, knowledge about the political and economic conditions in the country of investment is essential to understand the factors that could affect the investment returns. Investors must focus on their investment objectives, costs, and prospective returns, balancing it with their risk tolerance.