Domestic investors can add value to their portfolio by investing in the large global markets though special considerations must be taken into account. Exchange rates is an added layer of risk and can be mitigated by hedging. Mutual funds and ETFs are a way to tap into this diversifying asset class.
Global Financial Markets
The value of global market is currently $69 trillion and 60% of it are on exchanges outside North America. The growth of Europe and Asia suggests the US market is becoming a declining part of the total.
This expansion suggests opportunities in not only developed markets but emerging markets as well. While specific markets have limited trading hours, the shares of large global American companies are traded in foreign exchanges allowing round the clock trading.
Special Considerations
US residents invest in foreign securities to earn a return through receipt of income, price appreciation and currency exchange fluctuation. In addition to dealing with the currency risk, political risk and local taxation must be considered.
The political climate is bigger factor than domestic because not only do the political parties change power, the whole political system might change overnight. The Arab spring, Cuba, Myanmar and military coup in Thailand are examples.
Foreign taxation complicates foreign investments and reduces the return earned by an individual. Foreign governments tax income and principal and generally withhold these funds before the US investors receives their funds.
Exchange Rates
In the case of foreign investments capital gains may occur because the value of the asset rises or because the value of the currency in which the asset is denominated rises. The value of currencies responds to changes in demand and supply for the currencies.
Currencies are traded daily in foreign exchange markets. Any imbalance in the demand or supply of a currency causes its price to change. This demand is related to the demand and supply of the goods and services the country produces and the flow of investments into and out of the country.
Discrepancies in interest rates between countries and differences in the rate of inflation also affect exchange rates. Declines in interest rates or increased inflation encourage currency to flow to countries with the highest rates or more stable prices
Risk Reduction Through Hedging
If the prices of currencies were stable, there would be little risk associated with currency price fluctuations, but this is not the case. Investors may reduce the risk of loss by hedging with derivatives, such as futures contracts. It requires the presence of speculators to accept the risk.
Individuals who acquire foreign securities purchase them for the returns offered by the investments, not the potential return offered by correctly anticipating changes in exchange rates. To hedge, an investor takes the opposite side for the hedge than his investment. They short the currency if they are long the investment or go long the hedge if they are short the investment.
Another strategy would be to less than fully hedged to offset costs. At least a measurable part of the risk has been eliminated. Another view is to not hedge at all, thinking if you can’t time the stock market, you can’t time currency fluctuations, thus saving hedging costs.
Advantages
The best advantage of investing in foreign investments is investing in economies and firms experiencing economic growth. While growth is not unique to foreign markets there are two other advantages, market inefficiency and diversification.
Foreign may not as efficient as the US because less analysis is applied to foreign securities and the results of this analysis may not be as widely disseminated. An astute investor may be able to isolate securities which are under- or over-valued. However, obtaining information is more difficult, more costly and often uses different account standards.
US returns are generally less volatile than foreign ones. The correlation or lack of it between annual returns on the US market and the foreign markets is marked by substantial year-to-year differences. This diversification effect has the result of reducing the variability of the overall portfolio.
Mutual Funds
From a US perspective, there are four types of mutual funds and ETFs with international exposure. These permit US investors an opportunity to invest without specialized knowledge of local firms and laws:
- Global funds- invest in foreign and US securities
- International funds- only invest in foreign securities
- Regional funds- specialize in a particular geographical area
- Emerging funds- specialize in securities located in less-developed nations
Many of the regional and emerging market funds are closed end and trade on US exchanges. The prices of these shares are very volatile since the price depends on both the fund’s net asset value and speculative interest.
Visit these topics for further detail or return to the Investment Basics page:
- Basics Introduction
- Security Markets
- Information Sources
- Risk and Portfolio Theory
- Investment Companies
- Stock Valuation
- Macroeconomic Environment
- Statement Analysis
- Bond Market
- Foreign Securities
The material presented on this page and Investment Basics pages were adapted from Dave’s lecture notes for the Investments for Professionals course taught at UCLA 1998-2005 and three decades of practical experience. See our Site Credits page for reference sources.
