The Case for Putting More Money Abroad
The question is no longer whether Americans should
invest abroad. It’s only what to buy and how much.
In this global economy, Americans should be investing abroad as comfortably as they do at home. Thousands of you do already. But to some investors, foreign markets still feel like too much of a gamble—especially when there’s a recession on.
I’d like to change your mind. In fact, I’d like to move you from developed markets (Europe, Japan) to the emerging ones, where the greatest growth will be (Southeast Asia, Latin America).
There are four strong reasons for putting some of your money abroad:
1. To invest in some of the world’s most powerful economic trends. These include the competition for oil, global demand for other commodities that lie in the hands of emerging countries, the development of Eastern Europe, the consolidation and restructuring of Western Europe, Latin America’s dramatic economic turnaround, the growth of consumer markets in Asia, the rise of China and India, the spread of sophisticated global communication, and demand for infrastructure such as roads and power lines. These trends will outlast the financial panic of 2007–2009. Two-thirds of the world’s investment opportunities now lie offshore.
2. To catch other countries’ business cycles. Over the long term, leading international companies do as well as similar companies in the United States. But over the shorter term, their stocks rise and fall at different times or at different rates of speed. Potentially, you can improve your returns by having a piece of the action, wherever it is.
3. To invest in currencies other than greenbacks. When you buy foreign stocks, you’re exchanging dollars for foreign currencies. Sometimes dollar-based investments give you the best international returns, sometimes foreign currencies do. Owning both is a way of spreading risk.
4. To reduce the risk to your investments overall. This surprises many investors, who assume that foreign stocks carry greater risks. Individually, they may, but not in combination with U.S. stocks. Foreign markets may be strong when U.S. markets are weak, and vice versa. When one market declines, another may rise. During major U.S. market drops, such as the bursting bubble of 2000 or the financial panic of 2007–2009, foreign and U.S. markets usually drop in sync. But over time, the diversification thesis holds.
Advisers suggest that you commit 20 to 30 percent of your portfolio to foreign stocks. Put the bulk of it into a large, well-diversified, stock-owning mutual fund, with perhaps 10 percent in emerging markets and 5 percent in an international small-company fund.
When you buy foreign securities, two factors influence how much money you’ll make or lose: (1) How well those particular foreign markets perform. Are stocks rising or falling? Are bond interest rates going up or down? Is the political or economic climate good or bad? These concepts are familiar to anybody who invests. (2) Which way the U.S. dollar moves. This is the unfamiliar part. The dollar connection leaves a lot of investors confused.
Sometimes the Dollar Declines on Certain International Currency Markets. The result: foreign securities rise in value, in dollar terms. As an example, take a $100 Japanese stock whose price in Japan remains unchanged. If the dollar drops by 5 percent against the Japanese yen, the dollar price of that stock will rise to $105. You will make money solely because of the currency change. The oversize international returns that U.S. investors earned during much of the first decade of this century came in part from the dollar’s general decline.
Sometimes the Dollar Rises on Certain Foreign Markets. American currency is worth more, while foreign currency is worth less. Result: foreign securities fall in value, in dollar terms. If you buy a $100 Japanese stock and the dollar rises 5 percent against the yen, your stock will be worth $95. Your loss came from the currency, not from any weakness in the underlying stock.
Some Countries Peg Their Currencies to the Dollar, but That Doesn’t Free You from Risk. These countries might loosen the peg, letting the dollar float (in these situations, it usually drops). Or they might repeg it at a lower rate.
Generally speaking, your foreign investments are helped by a falling dollar and hurt by a rising dollar. A country’s stock exchange may be flying in local-currency terms but look depressed to a U.S. investor because the dollar is going up. When the dollar moves down again, U.S. investors will show much better returns.
But the relationship between currency and investment performance isn’t exact. When the dollar rises against a national currency, that country’s products get relatively cheaper for American consumers. Its exports, corporate profits, and stock prices usually go up, which offsets your losses from the unfavorable currency change. The reverse may happen when the dollar declines. That country’s exports get more expensive, so its exports, profits, and stocks go down. Economic change offsets the effect of currency change.
Now you understand (I hope) why international investing needs to be a long-term proposition. Over the short term, currency change may dominate. Over the long term, however, the effects of currency cycles roughly cancel each other out—especially in well-diversified funds that invest in major markets. Long-term investors are hitched to international growth. Your capital gains will far outweigh the effects of short-term currency shifts.
It’s quite another story, however, for people invested in single-country funds—especially in emerging markets. There, a government-sponsored currency devaluation could hurt your returns for a considerable period of time.
Investors in foreign-currency bonds also shoulder a risk. Your long-term returns are lower than you’ll earn from stocks, so a negative currency change eats up proportionately more of your gain. In some years, your entire gain or loss comes entirely from currency fluctuation. Foreign bonds should be thought of as pure currency diversification—a bet against the dollar that should earn a competitive return over a long holding period. (The most widely traded emerging-market countries, such as Argentina, Brazil, and Russia, have debt denominated in dollars. In that case, there’s no currency risk.)
Every investment gain or loss in foreign markets come in two parts: changes in the market itself and changes in currency values, if any. Both contribute to your total return.
It’s hard to pick foreign stocks and bonds successfully. To do so, you have to follow foreign economies, politics, tax laws, financial news, and interest rates; the outlook for each foreign currency relative to the dollar; each company’s growth, profitability, and prospects; and the vagaries of each foreign stock market. That’s a lot. What’s more, you have to do your research without access to as much financial information or stock market data as is available in the United States. There’s less investor protection, less enforcement of securities laws, more stock manipulation, and more government interference than American markets tolerate.
Or you could buy mutual funds.
If ever there is an argument for mutual funds, it’s for buyers of international securities. Sit back, relax, and leave the driving to them.
International funds buy securities everywhere but the United States. For your first (or sole) foreign investment, this is the kind to own. Look for a big, diversified fund. It leans toward larger companies in the industrialized countries but usually allocates some money to emerging markets and smaller stocks too. With this investment, you stay in control of the portion of your total assets that you keep abroad. You also share in every type of international growth.
A growing number of international funds specialize in smaller stocks. They’re more volatile than big, diversified funds but ought to deliver higher capital gains, long term. You can also buy value funds that look for distressed companies, hoping they’ll recover and outperform.
Global funds buy stocks worldwide. As much as one-half of their assets could be invested in the United States. They’ll beat the pure international funds when the American market is strong and underperform them when it’s weak. At various times, you’ll have different portions of your money invested abroad, depending on what the manager decides to buy.
Regional funds stick to a local group of countries, such as Europe or the Pacific Rim. They’re bets on a particular part of the world, for those who think they know which part of the world is going to do the best. Some Pacific funds specifically exclude Japan, so they look good when Japan is in a funk. But they may trail when Japanese stock prices march up.
Emerging-markets funds buy stocks in the world’s rising countries in Eastern Europe, Asia, and Latin America. They’re more volatile than stocks in the developed world—meaning that they soar in rising markets and collapse in falling ones. On the other hand, the countries they invest in tend to be the fastest growing in the world. Their politics are reasonably stable, they’re reforming their economies on free-market lines, and they have a positive balance of payments. The big international fund that you own may invest a small percentage of its money in emerging markets. If not, or if you want a higher exposure to these countries, buy an emerging-markets fund, shut your eyes to the deep drops when global shares decline, and plan to hold for a very long time. In my view, emerging markets should be part of every diversified portfolio. They’re not optional anymore.
Frontier funds, the newest addition to the international list, buy stocks in corners of the world that you never thought of investing in before: Africa, the Caucasus, the Near East. The Gulf oil countries have been on the list too, but they may move to the “emerging” category. Frontier markets are wild, unpredictable, and poorly regulated, with small numbers of stocks, and subject to enormous economic, political, and currency risk. The reason to own them is globalization. Modern, commercial cultures are being created in places where they didn’t exist before.
At this writing, only one mutual fund has ventured into these waters: T. Rowe Price’s Africa & Middle East Fund. Exchange-traded funds will also be showing up. Frontier stocks are strictly for gamblers, but I’ll mention in passing that some of these stocks have enjoyed stupendous growth.
International index funds beat the actively managed funds, on average. For a discussion, see page 851.
Single-country funds are generally closed-end (page 788). That frees their managers to invest in small stocks, private placements, and illiquid issues—commonplace in very small markets—without worrying about how to pay off investors who want to cash out. If you want to quit the investment, you simply sell the shares on a stock exchange. Like any other closed-end fund, these should generally be bought only when they trade at a deep discount to the value of the securities in the fund’s portfolio (say, a discount of 10 to 15 percent or more). If you buy at a premium over the net asset value, you are usually setting yourself up for a loss. Ditto if you buy when the fund is first being offered to investors.
Even at a discount, any single-country fund carries extra risk. If that country’s market or currency hits a downdraft, so does your investment—and the manager can’t shift his or her money to a more profitable part of the globe. If a new closed-end fund for that particular country is introduced, investors may lose interest in the older fund, causing its price to drop.
Closed-ends are for people who want to roll the dice on a particular country. Don’t even think about it unless you know that country well and have taken the time to study how its fund price moves.
Exchange-traded funds (page 859) follow a multitude of foreign indexes. If an ETF is a better buy for you than a traditional mutual fund, look for one that follows a broad market index. Examples would be Vanguard’s FTSE All-World ex-US ETF (tracking all the world’s major stock indexes except the one in the United States) or its Emerging Markets ETF. You can also bet on narrow segments, such as Chinese real estate, but you might as well buy a lottery ticket.
There’s only one reason for a long-term investor to buy an international bond fund: you want to diversify against the dollar. If the dollar declines in value against the currencies represented by the bonds in the fund (euros, yen, and so on), the market price of your fund will rise. If the dollar rises against those currencies, the market price of your fund will fall. International bond funds are almost entirely currency plays, which makes them high risk.
You might be temped by a fund because it’s paying a higher current interest rate than you can get from bond funds in the United States. That’s not a good reason to invest.
There’s no free lunch in the interest rate market. If a bond is paying 10 percent in U.S. dollar terms when similar American bonds are at 5 percent, it means that the market expects a 5 percent rise in the dollar against that particular currency, to equalize yields. You’ll make extra money only if the market guessed wrong and the dollar doesn’t rise that far. The market may indeed guess wrong, but you’re betting against some of the best brains in the business.
International bond funds vary in how they handle currency shifts. Some adjust your dividends up and down as the dollar falls and rises. If you’re living on this income, you’ll find that your periodic payouts gyrate a lot. Other funds pay the full dividend and adjust for currency changes in other ways—maybe in the fund’s net asset value or maybe in your individual tax basis. These changes aren’t as noticeable if you’re reinvesting dividends.
The funds may try to stabilize their dividend payouts by hedging currencies and placing other arcane bets. The cost of hedging normally makes only a minor difference to a fund’s net asset value. On the other hand, one reason you invest abroad is for currency diversification, and hedging takes some or all of that away. If you haven’t diversified against the dollar, you’re losing one of the chief benefits of investing internationally.
Some advisers tout global bond funds instead of international funds because global funds include U.S. bonds. This limits your currency risk but also reduces your diversification. Surprisingly, a fund described as “international” might also buy U.S. securities, which defeats the very reason for owning them.
Over the long term, international diversification lowers the downside risk in a fixed-income portfolio. That’s because bond prices rise and fall in different countries at different times, so you’re usually getting good performance from at least part of your portfolio. For the average investor, however, the reduction in risk may be negligible. Owning international stocks is important; international bonds should be one of the last things you buy—if you buy them at all. In general, the potential reward is probably not worth the risk.
There’s an interesting argument, however, for tossing some money at bond funds invested in emerging-market debt: they’re more stable than they used to be. Assuming that these fast-growing countries gradually improve their credit ratings, you could get superior returns over the very long term. Play with a small amount of money (in your retirement account, if you have the option), and only if you’re an experienced investor.
If you depend on your capital for a steady income, homegrown bonds are generally best. If you want to gamble on higher total returns (including capital gains), add foreign-currency bond funds to the mix. If you do choose a bond fund, make it a no-load (because you don’t want sales charges cutting into your total return) or a closed-end fund selling at a decent discount.
Take care. Some of these investments advertise themselves as money market funds because they buy foreign money market instruments, such as short-term government securities and certificates of deposit. But the value of your shares isn’t held at one dollar, as is the case with real money funds. Instead your investment will fluctuate with changes in the dollar value of foreign currencies.
Although these mutual funds and ETFs earn interest, they’re almost entirely currency plays. Some buy just a single currency, some buy several. They’ll do moderately well when the dollar declines and badly when it rises. Their expenses are high, which takes a big bite out of their potential yield.
The same is true of the principal-protected foreign-currency baskets offered by some brokerage houses. You buy for a specified term. The basket contains complex long and short positions in various currencies. At the end of the term, you’re guaranteed your principal back plus a portion of the basket’s gain, if any. These baskets are complex and riddled with fees. Your return could easily be less than you’d get from a bank account.
It costs more to buy foreign securities than American securities. You pay for currency conversion and face much higher expenses for completing transactions. There are often big markups on securities prices, especially in emerging markets. As a result, global and international funds charge higher annual fees than domestic funds. Investors should consider exchange-traded funds, which carry lower fees than traditional, managed mutual funds, or international index funds. This is especially true if you’re buying bond funds or currency funds, where expenses can eat up the yield fast.
For how to account for foreign taxes paid by your fund, see page 784.
They’re offered by a small number of banks. You can get interest-paying money market funds and certificates of deposit denominated in Japanese yen, Canadian dollars, British pounds, the euro, and other currencies. Interest is paid in those currencies, and so are the fees charged.
At present, these accounts are used principally by companies that do business abroad and by travelers locking up the cost of their foreign vacations. For example, if you’re going to Germany six months from now and buy a six-month euro-denominated certificate of deposit, your vacation fund will be insulated from any changes in the value of the dollar. If you care.
Check your prospectus to see if your funds have the right to do so. Then check your semiannual reports to see if any foreign shares have actually been bought.
If all your funds together routinely keep around 20 percent of their assets in foreign stocks, you don’t have to buy an international fund in order to diversify. Your American funds have done it for you.
But, but, but: one or two of your funds may change their minds and sell part of their positions. You’d then have less foreign diversification than you’d intended. Furthermore, U.S.-based managers may not have as much success with foreign stocks. If things go badly, they might cut and run rather than prowl the world for other opportunities.
For better control of your asset allocation, split your money between pure U.S. funds and pure international funds. Separate funds also make it easier to measure your managers’ relative performance. An all-U.S. fund can be cleanly compared with a U.S. fund index. If it also contains international stocks, it’s harder to judge how good your manager actually is.
If you’re interested in doing your own securities and currency research and love individual stocks despite the drawbacks (page 713), there are several other roads to foreign investing:
Here’s an armchair way for your money to travel. Look for major U.S. companies that earn a large percentage of their profits abroad. Just a few examples: IBM, Coca-Cola, Microsoft, Procter & Gamble, and McDonald’s. Owning them gives you a stake in international growth as well as a minor currency play. Their foreign earnings are worth more when the dollar declines and less when the dollar rises. On the other hand, U.S. multinationals pretty much rise and fall with the S&P 500-stock index, so you aren’t truly diversifying your overall investment risk.
You’ll find the big names, such as BP, ING, Novartis, Nortel, Sony, Toyota, and UBS trading on the major U.S. exchanges or over the counter.
An indirect way of buying individual company stock, ADRs represent foreign shares that are held in the vaults of a custodian bank. You buy and sell them as if they were the stocks themselves. At this writing, more than 1,300 ADRs are offered to retail investors. Some are listed on the New York Stock Exchange, the NYSE Euronext, or on NASDAQ. Many trade through the pink sheets (page 868). You can also buy some through dividend reinvestment plans (page 834).
More than one-fourth of the ADRs are sponsored by the companies themselves. They give you American-style financial information (although not as quickly) and pick up the cost of administering the securities. The remaining ADRs are unsponsored, meaning that they’re managed by a bank without company involvement. With unsponsored ADRs, you usually get no financial reports. The administrative cost (maybe 2 to 4 cents a share) is deducted from your dividends. Many ADRs represent 1 share each, but some represent bundles of 5 or 10 shares or fractions of a single share.
Many of the listed ADRs attract a lot of buyers. But pink sheet issues are often illiquid. When you sell them, you’re apt to take a haircut on the price. Generally speaking, investors should stick with sponsored ADRs that are listed on NASDAQ or the U.S. exchanges and trade actively all the time. The trades settle in dollars. If the dividends are paid in a foreign currency, they’re exchanged for dollars by the depository bank and sent to the investor.
These are direct investments in individual stocks on foreign stock exchanges. You have access to thousands of shares that have no ADRs. The big brokerage firms, including the online discounters, offer a global investing service, although the costs are much higher than for speculations in U.S. shares. Not worth the price, it seems to me.
Absolutely not for the average buyer. They carry high minimum investments—often $25,000 to $50,000 or more. And it’s tough to make money on them after paying all the costs: currency conversion, brokerage commissions, transaction fees, and the profit that brokerage houses tack on to the price. Bond lovers should buy mutual funds instead.
In 2008, a financial panic enveloped the world. Stocks in foreign, developed countries did no better than U.S. stocks. Stocks in emerging countries fell off a cliff. Then the emerging countries staged a comeback, with stocks rising much faster than anywhere else. Growth will reassert itself in those parts of the world. The diversification story hasn’t changed.