The section describes the role of Foreign Securities in your portfolio. 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 are an added layer of risk and you can mitigate it by hedging. Mutual funds and ETFs are a way to tap into this diversifying asset class.
Foreign Securities Markets
The value of global market is currently $69 trillion and 60% of it are traded on exchanges outside North America. The growth of Europe and Asia implies 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.
US residents invest in foreign securities to earn a return through receipt of income, price growth and currency exchange movements. In addition to dealing with the currency risk, political risk and local taxes must be addressed.
The political climate is bigger factor than local, because not only do the their parties change power, the whole system might change overnight such as
- The Arab spring
- the army coup in Thailand
Foreign taxes muddy foreign investments and reduces your return earned. They tax income and gains awhile withholding these funds before you receive your funds.
In the case of foreign investments, gains may occur because the value of your asset rises or because the value of the currency in which your asset is valued rises. The value of currencies respond 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 funds 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
If the prices of currencies were stable, there would be little risk with currency price changes, but this is not the case. Investors may reduce the risk of loss by hedging 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, you take the opposite side for the hedge than your investment. You short the currency if you are long the investment or go long the hedge if you 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.
The advantages of investing in foreign investments
- Investing in economies and firms experiencing economic growth
- Market inefficiency– 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.
- Diversification– 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 your variability of the overall portfolio.
From a US perspective, there are four types of mutual funds and ETFs with international exposure. These permit you 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
- Statement Analysis
- Bond Market
The material presented in this section 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. Also, see our Site Credits page for reference sources.