The primary reasons to invest internationally are high returns and diversification. While foreign stocks are typically more volatile than U.S. stocks, adding international exposure to a portfolio will normally reduce the risk of the portfolio without lowering returns. A portfolio of 80% US stocks and 20% international stocks will likely have similar yields with less risk than a portfolio of 100% US stocks. There is however a historical relationship that investors should be aware of. When the U.S. market goes down sharply, the correlation with foreign markets goes up. In other words, the benefit of diversification is reduced during sharp downturns in the U.S. For example in the crash of 1987, most foreign markets also had large drops. A common wall street adage is "when the U.S. stock market sneezes, the rest of the world catches a cold." But over longer periods of time (months and years) the correlations between markets are low.
The negatives of investing internationally include higher expenses (transactions, management and custody fees), taxes issues, and operational issues (disclosure, accounting, etc.). Additionally, there are added political and currency risks. Investors should also keep in mind that returns from international investing can be heavily influenced by currency movements which can also result in higher volatility. When analyzing past performance, currency effects should be differentiated from local returns. When the dollar is appreciating, returns from foreign investing will be reduced and vice versa.
In an award winning article titled "Where Are the Gains from International Diversification?" (January-February 1996 issue of the Financial Analysts Journal) Rex Sinquefield questioned the arguments that diversified international portfolios and EAFE in particular (1) substantially diversify a U.S. portfolio and (2) have higher expected returns than the U.S. equity market. Based on empirical evidence (from Fama,
French,
Sharpe and others) from 1970-94, Sinquefield argues that two risk factors (value and size) explain differences in returns in both the U.S. and foreign market. Further he argues that international value and international small stocks diversify U.S. portfolios more than EAFE. Sinquefield therefore concludes that "a
sensible reason to diversify internationally is to 'load up' on value stocks and small stocks without concentrating in one geographic region." Why Invest Globally? is another opinion on the matter - by Jarrod W. Wilcox of PanAgora Asset Management.
International Investing Options include
- Mutual funds that buy foreign securities.
- World Equity Benchmark Shares (WEBS)
- Closed-end funds that buy foreign securities.
- Buying foreign securities directly.
- American Depository Receipt's (ADR's) - Foreign companies shares trading on US exchanges.
- Buying securities of American companies with foreign exposure. (This does give you some foreign exposure embedded in the security but the diversification benefit is not as strong as with investing in foreign securities.)
World Equity Benchmark Shares have been trading since March 1996 and offer a new way for investors to invest passively in individual foreign countries. They are denominated in US Dollars, trade close to Net Asset Value (NAV), can be bought, sold short, and margined like regular stock, and yield passive returns based on the index. They offer relatively low expense ratios around 1% or lower per year. The few negatives include no protection against currency fluctuations and an inability to automatically reinvest dividends. They trade much closer to NAV than most closed end funds because large aggregations called creation units can be created and redeemed at NAV. WEBS are particularly attractive for active allocation when you consider that studies show that for international equity investing, picking the right country accounts for roughly 60% of return, with security selection accounting for 25% and sector accounting for 15% of variations in returns.
WEBS were recently introduced by Barclays (overseen by Morgan Stanley) and trade like common stocks on the AMEX. They are open-end country funds which offer indexed exposure to 17 individual countries based on Morgan Stanley Capital International indices. Country Baskets were recently launched by Deutsche Morgan Greenfell/CJ Lawrence and traded on the NYSE but were discontinued early in 1997.
The issue of openness matching refers to the percentage of foreign goods in an investor's market basket. That is, an individual who purchases 10% of their goods from foreign sources should consider investing in foreign assets accordingly to "match" the future consumption needs. However, this perspective does not take into account the return and diversification benefits of international investing.
Investing directly in foreign securities creates a number of dynamics resulting from playing by the rules of the foreign countries. The range of reconciliation between foreign accounting and United States accounting goes from 0 to 100%. Foreign companies that list their stock on US exchanges provide full reconciliation to US standards while most foreign listed companies provide no reconciliation. (See also about financial statements.) The bottom line is that you can not make general conclusions about valuation levels in different countries without a thorough understanding of accounting and other differences between the countries.
Currency risk has a stronger affect on foreign bonds than on foreign stocks because bond markets are less volatile than stock markets. There is much debate over whether nondollar bond investment is worthwhile. The risk reduction is modest and given the expense and currency risk, many have concluded that for all but the largest funds, its an opportunity that investors can afford to pass up.
Robert D. Arnott
(President and CEO of First Quadrant) and Tan K. Pham argued (in an article titled "Tactical Currency Allocation," in the Financial Analysts Journal, September-October 1993) that currency markets are not completely efficient because "Two of the largest communities of currency traders have no profit motive. Central banks trade to dampen volatility. Corporations seek to hedge currency exposure in their book of business. . . . we conclude that currency markets are not efficient. Their inefficiencies follow a historically reliable patter, which is consistent with what we know about global capital flows. Any inefficiency is, of course, an arbitrage opportunity; if enough capital is invested in a fashion that exploits the inefficiency, it can and should disappear. However, the currency markets are large and liquid, and have a major class of investors (the central banks) that does not care about profits. Accordingly, we see no reason for these inefficiencies to dissipate quickly."
Studies have shown that an allocation of as high as 60% for international investments can provide improving risk/return benefits, but advisors commonly recommend allocations in the 10% to 30% range. A Greenwich Associates survey found that by year-end 1995 the average allocation to international securities for 1,592 large funds had risen from 1991's 4.4 percent to 10.4%. Ronald Liesching, director of research at currency-overlay manager Pareto estimated that funds with $1 billion or more in assets had international allocations averaging 18% (Source: Institutional Investor, "Hedging on hedges," June 96).
According to Institutional Investor ("Far from home" by Miriam Bensman, April 1996), International equities had $29 billion in net cash flows from US Pension funds in 1995 of which $13 billion was placed with index managers. $5 billion went into fixed income. The total of $34 Billion was down from 1994's $40 billion and 1993's 42 billion. CalPERS had roughly 20% of its $100 Billion fund allocated to international investments. According to Philip Halpern, CIO Washington State Investment Board, "Trading costs for international investing can be as much as 150 basis points a year, so your behind from the get-go. . . . If you include investment management fees of 50 to 100 basis points, you start 200 to 250 basis points behind the game with an active manager." The article added, "Emerging markets, of course, are exactly the sort of inefficient markets that appear likely to reward skilled stock picking. But big funds fear they'll swamp stocks by taking concentrated bets; in addition, the median manager in this category has underperformed. The reason: Transaction costs exceed even those for developed international markets, and money managers are inexperienced."
Trivia: What country was a top performer for three consecutive years in 91, 92, and 93 with annual returns of 50%, 32% and 117%? Answer
Emerging markets are typically defined as countries with low per capita GNP. While developing countries make up over 80% of the worlds population, they make up less than 10% of the world stock market capitalization. The benefits of investing in emerging markets include high returns and greater diversification, while the risks are greater than investing in developed countries. According to Boston-based Pioneering Management Corp., over the 50 years through 1995, emerging market equities showed average annual returns of 16.5% compared with 12.4% for the S&P 500 and 11.8% for the EAFE index (Source: Business Week 9/9/96). The Institute of International Finance estimated $33.1 billion flowed into emerging market stocks in 1996.
Additional difficulties include political uncertainty, lack of company information, lack of liquidity, trading and custodial difficulties, confidentiality and insider trading problems, as well as even higher transactions costs compared with developed countries. However, emerging markets as a group have much lower volatility than the individual markets because of low correlations between the markets. Industries play a larger role in explaining return of developing markets, while country differences play a larger role in the emerging markets. The Emerging Markets Companion is a site that offers news and quotes on emerging markets. See also All That Glitters is Gold? by Kristine Lino and Bruce Clarke of
PanAgora Asset Management, Peregrine Asset Management, and this Mutual Fund Cafe article on the surge in buying of emerging market funds.
Recommended Reading: Global Bargain Hunting: The Investor's Guide to Profits in Emerging Markets by Burton G. Malkiel and J. P. Mei
Trivia Answer: Hong Kong. Source: Morgan Stanley Capital International
Please send suggestions and comments to Investor Home