Risk & Return from Foreign Equity Investments

Investors who want to increase the diversification and total return of their portfolios are often advised to get into international assets. Many hesitate to take that advice.

There are, in fact, three big risks that investors add when they enter international investing. Knowing what they are and how you can mitigate those risks may help you decide if going global is worth the risk and potential rewards.

International equity is a great way to get exposure to companies and sectors which are not available in the Indian markets. E-commerce, search engines, payment infrastructure, cloud computing, electric mobility, enterprise software, digital OTT platforms are some of the sectors which are showing good growth globally but we don’t have listed companies in India. Exposure to international equity also provides us a hedge against the depreciating rupee, which can also add to returns in the long term. It also helps us to diversify our portfolio outside our home country, which will prove helpful in the long run.

1. Higher Transaction Costs

The biggest barrier to investing in international markets is the added transaction cost. Yes, we live in a relatively globalized and connected world, but transaction costs still vary greatly depending on which foreign market you are investing in. Brokerage commissions in international markets are almost always higher than U.S. rates.

2. Currency Volatility

When investing directly in a foreign market (and not through ADRs), you first have to exchange your U.S. dollars into a foreign currency at the current exchange rate.

Say you hold the foreign stock for a year and then sell it. That means you will have to convert the foreign currency back into USD. That could help or hurt your return, depending on which way the dollar is moving. It is this uncertainty that scares off many investors.

A financial professional would tell you that the solution to mitigating currency risk is to simply hedge your currency exposure. The available tools include currency futures, options, and forwards. These are not strategies most individual investors would be comfortable using.

A more user-friendly version of those tools is the currency exchange-traded fund (ETF). Like any ETF, these have good liquidity and accessibility and are relatively straightforward.

3. Liquidity Risks

Another risk inherent in foreign markets, especially in emerging markets, is liquidity risk. This is the risk of not being able to sell an investment quickly at any time without risking substantial losses due to a political or economic crisis.

There is no easy way for the average investor to protect against liquidity risk in foreign markets. Investors must pay particular attention to foreign investments that are or may become illiquid by the time they want to sell.

There are some common ways to evaluate the liquidity of an asset. One method is to observe the bid-ask spread of the asset over time. An illiquid asset will have a wider bid-ask spread relative to other assets. Narrower spreads and high volume typically point to higher liquidity.

Minimizing Currency Risk

Despite the perceived dangers of foreign investing, an investor may reduce the risk of loss from fluctuations in exchange rates by hedging with currency futures. Simply stated, hedging involves taking on one risk to offset another. Futures contracts are advance orders to buy or sell an asset, in this case, a currency. An investor expecting to receive cash flows denominated in a foreign currency on some future date can lock in the current exchange rate by entering into an offsetting currency futures position.

In the currency markets, speculators buy and sell foreign exchange futures to take advantage of changes in exchange rates. Investors can take long or short positions in their currency of choice, depending on how they believe that currency will perform. For example, if a speculator believes that the euro will rise against the U.S. dollar, they will enter into a contract to buy the euro at some predetermined time in the future. This is called having a long position. Conversely, you could argue that the same speculator has taken a short position in the U.S. dollar.

There are two possible outcomes with this hedging strategy. If the speculator is correct and the euro rises against the dollar, then the value of the contract will rise too, and the speculator will earn a profit. However, if the euro declines against the dollar, the value of the contract decreases.

When you buy or sell a futures contract, as in our example above, the price of the good (in this case the currency) is fixed today, but payment is not made until later. Investors trading currency futures are asked to put up margin in the form of cash and the contracts are marked to market each day, so profits and losses on the contracts are calculated each day. Currency hedging can also be accomplished in a different way. Rather than locking in a currency price for a later date, you can buy the currency immediately at the spot price instead. In either scenario, you end up buying the same currency, but in one scenario you do not pay for the asset upfront.

Investing in the Currency Market

The value of currencies fluctuates with the global supply and demand for a specific currency. Demand for foreign stocks is also a demand for foreign currency, which has a positive effect on its price. Fortunately, there is an entire market dedicated to the trade of foreign currencies called the foreign exchange market (forex, for short). This market has no central marketplace like the New York Stock Exchange; instead, all business is conducted electronically in what is considered one of the largest liquid markets in the world.

There are several ways to invest in the currency market, but some are riskier than others. Investors can trade currencies directly by setting up their own accounts, or they can access currency investments through forex brokers.

However, margined currency trading is an extremely risky form of investment, and is only suitable for individuals and institutions capable of handling the potential losses it entails. In fact, investors looking for exposure to currency investments might be best served acquiring them through funds or ETFs and there are plenty to choose from.

Some of these products make bets against the dollar, some bet in favor, while other funds simply buy a basket of global currencies. For example, you can buy an ETF made up of currency futures contracts on certain G10 currencies, which can be designed to exploit the trend that currencies associated with high-interest rates tend to rise in value relative to currencies associated with low-interest rates. Things to consider when incorporating currency into your portfolio are costs (both trading and fund fees), taxes (historically, currency investing has been very tax inefficient) and finding the appropriate allocation percentage.

Benefits of International Equity

• Diversification

Diversification is the most obvious yet the most crucial benefit of global investing. A diversified portfolio acts as a source of stability during market volatility.

When you spread out your investments across geographies, there is a low correlation between them. This means that the volatility in one market is likely not to affect your other assets.

Many of the US-listed companies have global revenues. Over 40% of the revenues of the S&P500 companies come from outside the US. By investing in the US itself, you can build a globally diversified portfolio.

• Wide range of investment options

Global investing enables you to access investment opportunities that are not present domestically. Developed markets like the US are home to some of the world’s largest tech companies something you cannot access by investing in India.

You may even choose a theme or a combination of multiple sectors. For example, you can prefer the US market for technology, Europe for engineering, and Australia for commodities.

If you are interested in healthcare or pharmaceuticals, there are several options in the US and Europe.

You can access multiple geographies through ETFs. For example, you can invest in German equities through the US-listed EWG ETF or in the Brazilian market through the EWZ ETF.

• Investment Protection

Another significant benefit of global investing is the protection of investments against fraud and liquidations.

Developed market companies generally have strong regulations that ensure sound corporate governance and severe penalties for market abuse. This protects retail investors from potential scams and insider trading losses.

Remember, capital is always at risk, but many foreign financial institutions, offer protection from seizures and other threats such as liquidation of the broker-dealer. For instance, in the US, SIPC protects investments up to $500,000 if your broker-dealer faces liquidation.

• Currency Diversification

Investing overseas exposes you to currency appreciation (or depreciation). For example, the USD has been appreciating, on average, between 3-5 percent versus the INR over the last few years.

Emerging markets’ currencies depreciate over the longer term. Interest rates in domestic savings accounts are at a low of 3-4 percent on average.

By investing globally, portfolios have generally had the dual benefit of better markets and appreciating currencies.