It is no secret that the US economy is on shaky grounds: the housing market bubble is collapsing, we are most likely in or entering another recession, inflation is starting to increase, consumer and public debt are both out of control, credit is extremely tight, the dollar is weak and falling, and banks are starting to fail. This is just the beginning of the United States’ economic troubles. Those people who are invested only in the US stock markets expecting to see 8-10% long-term annual gains are going to be in for a big surprise when they realize that these average gains were the result of one of history’s greatest economic bull markets. Just looking at the chart of the Dow Jones Industrial Average over its history should scare any US investor.
These facts give strong support for the need to diversify internationally, a strategy that has the potential to both increase gains and reduce risk. Most people think about international investing as risky speculation: putting money in markets that may be unstable or extremely volatile. What most people do not understand, however, is that international investing can actually reduce the amount of risk you hold in your portfolio.
Risk Diversification
Many foreign markets move in a similar fashion to the US markets, given the fact that the US economy is currently at the epicenter of the world economy. When the US markets increase, many markets around the world tend to do the same. This also occurs when the US markets fall. Nevertheless, foreign countries have their own local economies that are independent of the US economy, creating opportunities to gain when the US markets decline. This is called risk diversification, meaning that there is potential to reduce risk by including investments that move independently of US markets.
Opportunities for Superior Performance
Risk reduction is not always the objective of a portfolio. There are many scenarios where an investor desires to increase risk to increase potential returns. Foreign markets hold many opportunities to achieve returns far superior to US returns, and historically this has been the case. Brazil, for example, has seen enormous gains in the past years. Since 2001, the S&P 500 has returned only 5.8%, while the Brazilian stock market returned almost 400% over the same period. With more countries improving their economic situation and investment environment, there are many opportunities to see gains similar to those of the Brazilian markets.
Risks
As with any investment, international markets pose risks... many of these risks we see in US markets, but there are other risks that are unique to international investing. These risks include political risk, currency risk, market risk and information risk.
How to invest
Each day the global markets are becoming more and more integrated, making it easier to invest in foreign companies. Nevertheless, international investing still has limits, so there are only a few options open to a normal investor wanting to purchase shares of foreign companies.
Mutual funds might be the most common and simplest way to invest, but also the most costly. Funds might charge a load, or a sales fee to invest, management fees, 12b-1 fees (distribution fees), redemption fees, etc. All of these fees add up to reduce your investment returns in the funds.
ADR’s, or American Depository Receipts, are shares of foreign companies traded on US exchanges, making it simple for US investors to purchase these companies through their brokers. Many of the larger, well established foreign companies trade on US exchanges. Investing in ADR’s allows investors to choose the companies that fit best in their portfolios, rather than leave the decisions up to a mutual fund manager. The drawback is that this strategy requires more research, and it introduces more information risk, which is the risk that information is either not available or not accurate.
One of the best ways currently available to US investors to invest internationally is through Exchange Traded Funds. ETF’s are available for many countries that allow US investments, and there are also ETF’s that track regions or baskets of countries. ETF’s typically have lower fees than a typical mutual fund, and diversification is simpler and less costly than with ADR’s. One of the risks that is still present in ETF investing is a lack of liquidity. Many international funds have low trading volume, making it more difficult to sell when you may want, or it may have to accept a lower price to sell your ETF and a higher price to buy.
Many US companies conduct a significant portion of their business overseas, allowing investors to diversify internationally while still holding US companies. Some of the better-known examples are Coca-Cola, Procter & Gamble, Caterpillar, and Du Pont. As with any investment, international investing has its risks, but these risks may be far less costly than the risk of failing to diversify out of US holdings.
Steven F. Schreiber holds a BA in Economics and International Studies from the University of Richmond, as well as an MBA with a specialization in Finance from the University of Miami. He is a Chartered Financial Analyst, a member of the CFA Society of Orlando, and a member of the CFA Institute.