Investing internationally has often been the advice given to
investors looking to increase the diversification and total return of their
portfolio. The diversification benefits are achieved through the addition of
low correlation assets of international markets that serve to reduce the
overall risk of the portfolio. However, although the benefits of investing
internationally are widely accepted theories, many investors are still hesitant
to invest abroad. In this article, we'll discuss the reasons why this may be
the case and help highlight key concerns for investors so they can make a more
informed decision.
Transaction Costs
Likely the biggest barriers to investing in international
markets are the transaction costs. Although we live in a relatively globalized
and connected world, transactions costs can still vary greatly depending on
which foreign market you are investing in. Brokerage commissions are almost
always higher in international markets compared to domestic rates. In addition,
on top of the higher brokerage commissions, there are frequently additional
charges that are piled on top that are specific to the local market, which 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:
Fee Type Fee
Brokerage Commission HK$299
Stamp Duty 0.1%
Trading Fees 0.005%
Transaction Levy 0.003%
TOTAL HK$299 + 0.108%
In addition, if you are investing through a fund manager or
professional manager, you will also see a higher fee structure. To become
knowledgeable about a foreign market to the point where the manager can
generate good returns, the process involves spending significant amounts of
time money on research and analysis. These costs will often include the hiring
of analysts and researchers who are familiar with the market, accounting
expertise for foreign financial statements, data collection, and other
administrative services. For investors, these fees altogether usually end up
showing up in the management expense ratio.
One way to minimize transaction costs on buying foreign
stock is through the use of American Depository Receipts (ADRs). ADRs trade on
local U.S. exchanges and can typically be bought with the same transaction
costs as other stocks listed on U.S. exchanges. It should be noted however,
that although ADRs are denominated in U.S. dollars, they are still exposed to
fluctuations in exchange rates that can significantly affect its value. A
depreciating foreign currency relative to the USD will cause the value of the
ADR to go down, so some caution is warranted in ADRs.
Currency Risks
The next area of concern for retail investors is in the area
of currency volatility. When investing directly in a foreign market (and not
through ADRs), you have to exchange your domestic currency (USD for U.S.
investors) into a foreign currency at the current exchange rate in order to
purchase the foreign stock. If you then hold the foreign stock for a year and
sell it, you will have to convert the foreign currency back into USD at the
prevailing exchange rate one year later. It is the uncertainty of what the
future exchange rate will be that scares many investors. Also, since a
significant part of your foreign stock return will be affected by the currency
return, investors investing internationally should eliminate this risk.
The solution to mitigating this currency risk, as any
financial professional will likely tell you, is to simply hedge your currency
exposure. However, not many retail investors know how to hedge currency risk
and which products to use. There are tools such as currency futures, options,
and forwards that can be used to hedge this risk, but these instruments are
usually too complex for a normal investor. Alternatively, one tool to hedge
currency exposure that may be more "user-friendly" for the average
investor is the currency ETF. This is due to their good liquidity,
accessibility and relative simplicity.
Liquidity Risks
Another risk inherent in foreign markets, especially in
emerging markets, is liquidity risk. Liquidity risk is the risk of not being
able to sell your stock quickly enough once a sell order is entered. In the
previous discussion on currency risk we described how currency risks can be
eliminated, however there is typically no way for the average investor to
protect themselves from liquidity risk. Therefore, investors should pay
particular attention to foreign investments that are, or can become, illiquid
by the time they want to close their position.
Further, there are some common ways to evaluate the
liquidity of an asset before purchase. One method is to simply observe the
bid-ask spread of the asset over time. Illiquid assets will have wider bid-ask
spread relative to other assets. Narrower spreads and high volume typically
point to higher liquidity. Altogether, these basic measures can help you create
a picture of an asset's liquidity.
Bottom Line
Investing in international stocks is often a great way to
diversify your portfolio and get potentially higher returns. However, for the
average investor, navigating the international markets can be a difficult task
that can be fraught with challenges. By understanding some of the main risks
and barriers faced in international markets, an investor can position
themselves to minimize these risks. Lastly, investors face more than just these
three risks when investing abroad, but knowing these key ones will start you
off on a strong footing.
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