International equity investing has grown substantially during the past two decades and now represents a
a significant portion of investors’ total equity portfolios.
International equity represented less than 1% of individual equity allocations until recently. The rapid growth of acceptance of foreign investments occurred primarily for the following reasons:
- Deregulation of the financial markets of the major industrialized countries.
- Development and growth of global and multinational companies and organizations.
- The explosive growth of international capital flows and the concurrent abolishment of foreign exchange control.
- Advances in information technology.
Reasons for International Investing
Diversification
One of the significant advantages of international investing is diversifying the source, magnitude, and timing of returns for the investor’s overall portfolio. Foreign equity markets primarily respond to the unique political, economic and financial factors associated with the countries where the foreign company operates. These factors result in share price movements that can differ in size and timing, versus trends in the investor’s domestic equity markets, in all but the most extreme situations.
Exposure to Diverse Markets
Emerging markets are those non-developed countries with high rates of economic growth. These countries might be in the process of becoming increasingly industrialized or may still be significantly agrarian. There are local capital markets, some financial infrastructure, and regulations, but emerging markets do not have the same market efficiency or regulation level as developed economies.
Exposure to Unique Companies
Many industries and companies in foreign markets have world-class operations and dominate or compete very effectively in the global environment. Therefore, international investing allows domestic investors to gain exposure to these particular companies. Current examples include exposure to American, Japanese, European, and South Asian companies specializing in technology and manufacturing, including nanotechnology, chip manufacturing, auto and defense technology, etc.
Risk in International Investing
Risk and reward are simple facts of investing. However, with international investing, there are some additional risks that you need to know about.
Foreign Exchange Risk
Almost all international investment involves foreign exchange risk or currency. The most direct foreign exchange-related risk is that the market price of the foreign equity is not priced in the investor’s currency. For example, suppose the value of the foreign currency in which the share price is denominated falls relative to the investor’s home currency during the securities holding period. In that case, the value of the investor’s foreign holdings will decrease immediately.
Sovereign Risk
It can be difficult for investors to understand the political, economic, and social factors that influence foreign capital markets. This risk generally increases and can become significant as the investor moves his focus toward emerging markets. Some countries do not have a long history of operating in relatively stable domestic economies or financial markets.
Sovereign risk also arises from the product markets the foreign company is selling to. As a result, the foreign company is exposed to sovereign risk, affecting the company and its share value. An example of this would be an Indian investor holding an investment in a U.S. technology company listed on the NYSE with its offices in some Asian country. Due to some political unrest, its assets are confiscated by the government in the Asian region.
Liquidity Risk
In general, from the individual investor’s perspective, liquidity is not a problem in the majority of mid-cap and large-cap issuers in most of the international equity markets. However, liquidity does start to drop off dramatically for small-cap names in many international markets. In market stress, liquidity disappears more quickly in international markets than domestic equity markets. Concurrent with less liquidity, the bid-ask spreads tend to be more significant for international issuers than their domestic counterpart. This essentially translates into higher costs (for both buying and selling) in these markets.
Expenses
Investment in international equities typically involves higher expenses than a comparable investment in domestic equities. Almost all investment-related fees, ranging from broker commissions and stock exchange fees to custodial and administrator fees, are generally higher than those associated with domestic equity investments, occasionally by a significant margin.
These higher transaction-related fees, coupled with higher investment manager fees for international investment services, generally result in international equity and global equity mutual funds having the highest management fees of any mutual fund.
What are Foreign Investment Products?
There are three primary ways for investors to invest internationally.
Direct Investment
Generally, this type of foreign investment is the riskiest method of obtaining exposure to international investment. Direct investment can occur in two primary ways.
- First, the investor can invest in a foreign company on a direct basis as a private placement or investment in unlisted security. This option is not generally within the realm of the typical domestic investor. It should only be undertaken by those individuals with extensive knowledge and experience of the company and the country’s sovereign risks.
- The second and more popular form is the purchase of publicly-traded shares of individual foreign companies. Unfortunately, this is generally considered the second most risky method of international investment. This investment requires a complete set of investor skills for successful international investing. Moreover, it carries the additional (and often significant) risk that the investor’s international investment portfolio will not be sufficiently diversified.
Direct investment in international equities is usually accomplished by purchasing the equities of the foreign company directly on the foreign company’s domestic stock exchange. This involves several brokerages, custodial and administration challenges, and additional expenses for domestic investors.
Alternatively, American Depositary Receipts (ADRs) are a more efficient direct international equity investment method. Buying ADRs is the equivalent of buying the company’s common stock on the investor’s domestic exchange. ADRs are exchange-listed shares of a trust or unique purpose company (SPC) whose sole purpose is to hold a certain number of common shares of the issuer’s stock. These pledged shares form the collateral for the ADRs trust. They are deposited with a custodian bank or other reliable financial intermediary in the home country of the underlying company. ADRs are issued only for the most liquid and well-known international companies. ADSs are only listed on U.S. stock exchanges.
Mutual Funds
Domestically distributed mutual funds with international investment mandates have historically been the most popular and recommended method for international investment exposure. In addition, most mutual fund companies offer some form of a foreign equity fund, often in more than one mandate.
International investment through mutual funds provides the advantages of diversification, dedicated professional investment management expertise, liquidity, and so forth. Funds are offered in both a passive and active investment management style. Passive-style mutual funds are designed to track international or global equity benchmarks. On the other hand, some active international mutual funds are run by managers with decades of experience in international equity markets.
Exchange-Traded Funds (ETFs)
ETFs have quickly and firmly established their place in the investment options available to investors – individual and institutional. In addition, the growing popularity of international investing and investing in ETFs has resulted in an explosion in the number and types of ETFs with international investment objectives available to domestic investors.
Bottomline: International Investing; A Global Feather in Investor’s Hat
Expansion of international investment allocations within domestic investor portfolios is likely the way of the future. Driving this trend is the need for more significant return opportunities that cannot be found within the investor’s borders and the progress of greater integration of world economies and capital markets. Also adding to the trend is innovation in international investing vehicles. New products are providing progressively easier access to international capital markets.
International investing provides the advantages of diversification, exposure to the high-growth economies of both emerging and developed markets, and exposure to unique companies with no peers in the domestic financial markets.
