How to Invest: International Markets

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Welcome to How to Invest. In this article:

• Main Feature: International Investing: Expanding Your Portfolio Beyond Borders

• Investment Ideas for All Budgets

• Educational Corner: Understanding Currency Risk

• Did You Know? A Quick Financial Fact

International Investing: Expanding Your Portfolio Beyond Borders

International investing involves purchasing securities from companies and governments outside your home country. While domestic investments often form the core of most portfolios, adding international exposure provides access to global growth opportunities, diversification benefits, and potential currency advantages. With approximately 95% of the world's population and over 75% of global economic output occurring outside the United States, limiting investments to domestic markets means missing significant opportunities. This section explores the fundamentals of international investing, including market classifications, investment approaches, potential benefits, and unique risk considerations.

Understanding Global Market Classifications

International markets are typically categorized based on their economic development and financial market sophistication:

• Developed Markets: Countries with advanced economies, established regulatory frameworks, and highly liquid markets. Examples include Japan, Germany, the United Kingdom, Canada, Australia, and Switzerland.

• Emerging Markets: Nations experiencing rapid growth and industrialization with improving market infrastructure but higher volatility. Major emerging markets include China, India, Brazil, South Korea, Taiwan, South Africa, and Russia.

• Frontier Markets: Smaller, less accessible markets with developing economies and financial systems. Examples include Vietnam, Nigeria, Kenya, Morocco, and Romania.

Each category offers distinct risk-return profiles, with developed markets generally providing more stability and emerging/frontier markets offering higher growth potential accompanied by increased volatility and risk.

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Approaches to International Investing

Investors can access international markets through several investment vehicles:

1. International Stocks Direct ownership of foreign companies through American Depositary Receipts (ADRs) traded on U.S. exchanges or through purchasing shares on foreign exchanges.

2. International Mutual Funds and ETFs Professionally managed portfolios providing instant diversification across multiple international securities, regions, or specific countries.

3. Global Bonds Fixed-income securities issued by foreign governments or corporations, offering interest income and potential currency benefits.

4. International Real Estate Exposure to global property markets through international REITs, real estate funds, or direct property ownership.

5. Multinational Corporations U.S.-based companies with significant international operations providing indirect global exposure.

These approaches can be combined based on an investor's objectives, expertise, and risk tolerance.

Potential Benefits of International Investing

1. Diversification International markets often move differently than domestic markets, potentially reducing overall portfolio volatility and improving risk-adjusted returns.

2. Growth Opportunities Emerging economies frequently grow at faster rates than developed nations, potentially offering higher investment returns.

3. Valuation Advantages International markets sometimes trade at lower valuations than U.S. markets, providing potential value opportunities.

4. Currency Benefits When the U.S. dollar weakens against foreign currencies, returns from international investments can be enhanced when converted back to dollars.

5. Sector Exposure Some industries are better represented outside the U.S., such as luxury goods in Europe or semiconductor manufacturing in Taiwan.

Unique Risks of International Investing

1. Currency Risk Fluctuations in exchange rates can significantly impact returns when converting back to your home currency, either enhancing or reducing investment performance.

2. Political and Regulatory Risk Changes in government, policy shifts, or regulatory environments can affect foreign investments more substantially than domestic ones.

3. Information Asymmetry Less accessible or timely information about international companies and markets can create knowledge disadvantages.

4. Liquidity Concerns Some international markets, particularly frontier markets, may have limited trading volume and less efficient price discovery.

5. Tax Complexities International investments may involve withholding taxes, complex reporting requirements, or limited tax treaty benefits.

Understanding these dynamics allows investors to incorporate international elements strategically within a diversified portfolio, balancing the growth and diversification benefits against the unique risks and complexities of global investing.

Investment Ideas for All Budgets

For Small Investors (1 to 100 Dollars)

Fractional Shares of International ETFs

Description: Fractional share investing allows access to diversified international ETFs with minimal capital, providing exposure to developed and emerging markets through a single purchase.

Advantages:

• Immediate global diversification with minimal investment

• Professional management of currency, country, and security selection

• Elimination of direct foreign trading costs and complexities

• Low ongoing expense ratios compared to actively managed funds

• Ability to gain exposure to otherwise inaccessible markets

Limitations:

• Less control over specific country or company allocations

• Potential tax inefficiencies from fund distributions

• Limited ability to customize exposure based on personal views

• Some brokerages may not offer fractional shares for all international ETFs

Implementation:

• Research broad international ETFs like VXUS (Vanguard Total International Stock ETF), EFA (iShares MSCI EAFE ETF), or IEMG (iShares Core MSCI Emerging Markets ETF)

• Start with developed market exposure before adding emerging markets

• Use dollar-cost averaging with regular small contributions

• Enable dividend reinvestment to compound returns

• Consider tax-advantaged accounts to minimize tax implications

For Medium Investors (101 to 10,000 Dollars)

Regional and Country-Specific Allocation

Description: With a medium-sized budget, investors can create a more tailored international portfolio combining broad international funds with specific regional or country ETFs to overweight promising markets or regions.

Advantages:

• More precise control over geographical allocation

• Ability to adjust exposure based on regional economic cycles

• Can capitalize on specific country growth stories or valuations

• Flexibility to increase or decrease emerging market exposure based on risk tolerance

• Still benefits from professional management of security selection

Limitations:

• Higher research requirements to identify promising regions

• Increased complexity in portfolio management

• Potentially higher overall expense ratios when using country-specific funds

• More frequent rebalancing needs as different regions perform differently

Implementation:

• Build a core position (60-70%) using broad international ETFs

• Add satellite positions (30-40%) in specific regions or countries based on research

• Consider regional ETFs like:

  • EZU (iShares MSCI Eurozone ETF)

  • AAXJ (iShares MSCI All Country Asia ex-Japan ETF)

  • EWJ (iShares MSCI Japan ETF)

  • MCHI (iShares MSCI China ETF)

• Rebalance annually to maintain target allocations

• Consider currency-hedged versions for developed market exposure during periods of dollar strength

For Large Investors (10,000 Dollars and Above)

Comprehensive Global Asset Allocation

Description: Larger portfolios can implement sophisticated international strategies incorporating multiple asset classes (equity, fixed income, real estate) across global markets, potentially including direct ownership of ADRs or foreign ordinaries.

Advantages:

• Multi-asset exposure provides more complete global diversification

• Ability to incorporate international dividend strategies

• Can include direct ownership of selected international blue-chip companies

• Opportunity to add alternative investments with international exposure

• Better tax optimization across various account types

Limitations:

• Significantly higher complexity requiring more research and monitoring

• Potential foreign tax implications requiring specialized knowledge

• Currency risk management becomes more critical

• Need for more sophisticated rebalancing approach

Implementation:

• Core international equity allocation (40-50% of international portion)

• International fixed income (20-30% of international portion)

• Emerging markets allocation (15-25% of international portion)

• Global real estate exposure through international REITs (5-10%)

• Consider adding 8-12 high-quality ADRs for direct international blue-chip exposure

• Implement specialized approaches like international dividend growth or international small caps for additional diversification

• Develop systematic currency hedging strategy for fixed income portions

• Consider consulting with an advisor specializing in global investments

• Review international tax treaties and implications for direct foreign investments

Educational Corner: Understanding Currency Risk

When investing internationally, currency fluctuations can significantly impact your returns—sometimes even overshadowing the performance of the underlying investments themselves. Understanding and managing this unique dimension of international investing is essential:

1. How Currency Risk Works

   • Basic Mechanics: When you invest in foreign securities, you're implicitly making two investments: one in the security itself and another in the local currency

   • Return Components: Your total return consists of: (1) the security's performance in its local currency, and (2) changes in the exchange rate between that currency and your home currency

   • Amplification or Reduction: Currency movements can either amplify or reduce your returns when measured in your home currency

   • Example: If a Japanese stock rises 10% in yen terms, but the yen falls 8% against the dollar during the same period, your dollar-denominated return would be only about 1.2%

2. Currency Risk Scenarios

   • Dollar Strengthening: When the U.S. dollar strengthens against foreign currencies, returns from international investments are reduced when converted back to dollars

   • Dollar Weakening: When the U.S. dollar weakens, international returns are enhanced when converted back to dollars

   • Historical Pattern: Over very long periods, currency fluctuations have tended to even out, but significant multi-year trends in currency strength can substantially impact medium-term returns

3. Managing Currency Risk

   • Currency-Hedged Products: Many ETFs and mutual funds offer currency-hedged versions that use derivatives to neutralize currency fluctuations

   • Partial Hedging: Some investors hedge 50% of their international exposure as a middle-ground approach

   • Strategic Timing: Consider increasing hedged exposure when the dollar appears undervalued and reducing it when overvalued

   • Diversification Across Currencies: Exposure to multiple currencies can reduce the impact of any single currency's movement

   • Longer Time Horizons: Currency fluctuations often balance out over extended periods, making hedging less critical for very long-term investments

4. Currency Hedging Trade-offs

   • Cost Consideration: Hedging involves ongoing expenses that reduce returns during favorable currency movements

   • Diversification Impact: Unhedged currency exposure can actually enhance portfolio diversification during certain market conditions

   • Emerging Market Complexity: Currency hedging for emerging markets is often more expensive and less efficient than for developed markets

   • Natural Business Hedges: Multinational companies often have their own internal currency hedging strategies through global operations

By understanding these dynamics, investors can make more informed decisions about whether, when, and how much to hedge currency risk in their international investments. For many individual investors, a combination of hedged and unhedged exposure provides a reasonable balance between protection and potential currency benefits.

Did You Know?

If a U.S. investor had restricted their portfolio to only domestic stocks over the past 50 years, they would have missed out on the world's best-performing stock market during 28 of those years. Countries including Austria, Denmark, Finland, Sweden, and even Japan have all experienced periods where they significantly outperformed U.S. markets. Perhaps most surprisingly, from 2000-2010 (the so-called "lost decade" for U.S. stocks when the S&P 500 produced negative returns), international markets like Australia delivered positive returns exceeding 8% annually to U.S. dollar-based investors. This illustrates why geographical diversification remains a fundamental principle of portfolio construction despite periodic outperformance by any single market.

That concludes this article of How to Invest. International investing expands your investment horizon beyond domestic borders, providing access to global growth opportunities, diversification benefits, and exposure to industries underrepresented in your home market. While adding unique considerations like currency risk and geopolitical factors, global investing can enhance long-term returns and reduce portfolio volatility when implemented thoughtfully. Whether starting with simple international ETFs or developing a comprehensive global asset allocation strategy, incorporating international elements into your investment approach acknowledges the increasingly interconnected nature of the world economy.