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Global Investing: How to Diversify with an International Portfolio

In an increasingly connected world, savvy investors are looking beyond domestic borders to diversify their portfolios and capitalize on global opportunities.

Please note that this article is written with a focus on North American investors and may not fully account for the unique financial regulations, tax laws and investment practices of other regions.

What are the pros and cons of global investing?

International investing is a strategy that offers advantages and challenges. It provides access to a range of opportunities in emerging markets and high-growth sectors that may be underrepresented in North America. International stocks offer the benefit of portfolio diversification as investors can spread their stakes across different markets and currencies.

Another advantage of investing in international markets is its positive impact on the global economy. Foreign direct investment can greatly impact wealth distribution and help develop successful economies.

A flourishing global economy also benefits North American investors as economic growth in foreign markets can increase the demand for goods and services from North America.

However, investing in foreign markets also exposes investors to risks. The value of foreign investments can be affected by currency fluctuations, and return on investment may be offset by transaction costs. Market volatility arising from political and economic instability in foreign markets can also negatively impact a stock’s performance.

Moreover, international investment involves navigating different regulatory frameworks and the potential unavailability or unreliability of information about foreign enterprises and markets compared to domestic ones. This difference poses a significant challenge in making well-informed investment decisions.

“The oft-stated purpose for foreign capital deployment is to seek higher returns, improve diversification, reduce aggregate return volatility and hedge loss of purchasing power of (the) home currency,” said Stephen Johnston, a private equity manager and director of Omnigence Asset Management. “The high-level tradeoffs are political and regulatory risk and enhanced administrative and tax complexity, depending on the foreign destination.’

Johnston continued:

“Pension plans are susceptible to this reasoning as they cannot invest in higher return niche domestic opportunities given their material capital deployment needs — not so for non-institutional investors.

“It follows then that many investors could, within reason, be agnostic as to the domicile of their investment holdings, as long as those holdings suitably enhance their portfolios along the parameters above and can be implemented at the scale suitable to their individual deployment needs.”

Global investing for beginners

While global investing may sound complex it can be relatively straightforward for North Americans.

To invest in specific stocks, one option is purchasing American depositary receipts (ADRs). ADRs are issued by US banks to foreign companies, with the bank acting as a depository holding the underlying foreign shares. ADRs represent shares of a foreign company trading on a US stock exchange, denominated in US dollars.

Similarly, global depositary receipts (GDRs) represent foreign company shares and are issued by depositary banks. However, while ADRs can only be traded on US stock exchanges, GDRs can be traded on stock exchanges around the world. They are typically denominated in US dollars, euros or British pounds.

A more risk-averse option is to invest in mutual funds or ETF. Both offer diversification and professional management services, relieving investors from selecting and monitoring individual investments. They can hold a range of assets, including stocks and bonds, currencies, crypto, real estate and commodities like oil and gold.

Both mutual funds and ETFs may focus on particular sectors of the economy such as technology, healthcare, energy or automotive manufacturing. Examples of sector-specific ETFs include the Technology Select Sector SPDR Fund (ARCA:XLK), the Vanguard Health Care Index Fund ETF (ARCA:VHT) and the Energy Select Sector SPDR Fund (ARCA:XLE).

Global sector funds hold sector-specific funds from different countries, such as the iShares Global Healthcare ETF (ARCA:IXJ), which includes pharmaceutical companies from the US, Switzerland and India, three countries with strong reputations in that industry. Meanwhile, the Vanguard Information Technology Index Fund ETF (ARCA:VGT) tracks the performance of tech companies in countries known for their lucrative tech sectors.

For its part, the Fidelity International Index Fund (MUTS:FSPSX) is a mutual fund tracking the performance of the MSCI EAFE Index, which includes stocks from Europe, Australasia and the Far East.

The iShares China Large-Cap ETF (ARCA:FXI) is a country-specific fund, while the Vanguard Total International Stock Index Fund ETF (NASDAQ:VXUS) covers a broad range of international companies.

Additionally, funds may track development-based markets, such as the Vanguard FTSE Emerging Markets All Cap Index ETF (TSX:VEE), the iShares MSCI Frontier and Select EM ETF (ARCA:FM) or the T. Rowe Price Global Stock Fund (NASDAQ:PRGIX), a mutual fund that invests in developed and emerging markets around the world.

Managed volatility mutual funds employ strategies to minimize risks associated with global investing like currency fluctuations, political instability and the differences in regulatory environments. They typically hold shares in low-volatility sectors like consumer staples and utilities or multinational stocks like Johnson & Johnson.

Reuters reported on LSEG’s most recent Lipper data reading for this past July, which shows US$601 million in inflows to global volatility funds, the first net inflow in 14 months. Analysts expect more to come as investors exercise caution ahead of the November election and interest rate cuts expected in September.

Some differences between ETFs and mutual funds make them more well-suited to individual investors. Mutual funds, unlike ETFs, do not trade on stock exchanges, and their prices are calculated once a day after the markets close. ETFs can also be bought and sold in any amount, whereas mutual funds often require a minimum investment. Furthermore, mutual funds are only required to disclose their holdings once every quarter, while ETFs disclose their holdings daily. Investors generally pay less in management fees for ETFs than they do for mutual funds.

Global indexes such as the MSCI World Index (WORLD:MSCI), FTSE Global All Cap Index (INDEXFTSE:GEISAC) and the S&P Global BMI (INDEXSP:SBBMGLU) provide a benchmark for the performance of various sectors and regions in the global equity markets. Many mutual funds and ETFs aim to replicate these indexes’ performance by investing in companies and sectors represented within these indexes.

Finally, investing in multinational corporations (MNCs) is an easy way to indirectly benefit from the dynamics of international economic integration. MNCs are businesses with a significant presence in at least two countries. They often engage in foreign direct investments and have a globalized production process with revenue, operations and profits spread across different countries. This means that your investment is indirectly exposed to the economic conditions and performance of the countries it operates in. Some examples are Apple (NASDAQ:AAPL) and Toyota (NYSE:TM).

More complex global investing strategies

Direct foreign investing is another avenue that is primarily undertaken by experienced investors, high-net-worth individuals or private equity firms with a deep understanding of global markets. It’s a complex process accompanied by tax implications and other challenges that require specialized knowledge and expertise.

Establishing a brokerage account through a local firm, such as Fidelity in North America, or a foreign brokerage account in the target investment country, like Degiro in Europe, or Saxo Markets in Asia is one way to get started. Sometimes, foreign companies list their shares directly on US exchanges through initial public offerings.

Investors can also access foreign stocks through global exchanges. One of the most well-known is the MERJ Exchange, a multi-market, multi-currency platform headquartered in the Seychelles. Others include the Nordic Stock Exchange, which operates in the Nordic and Baltic countries; the Johannesburg Stock Exchange, which lists companies from various African countries as well as some international stocks; and the Euronext, a pan-European exchange that primarily operates in the European Union but includes non-member the United Kingdom.

Euronext expanded into the Asia-Pacific region in 2019 by launching Euronext FX, its foreign exchange trading platform, in Singapore. Other exchanges that facilitate trading in Asia are the Hong Kong Stock Exchange, the Tokyo Stock Exchange and the Singapore Exchange.

Another strategy is carry trades, which involves borrowing money in a low-interest-rate currency and investing in a high-interest-rate currency. The profit comes from the interest rate differential between the two currencies.

For example, until recently the Japanese yen had a very low interest rate compared to the US dollar. Investors could borrow yen, convert it to dollars and invest in US assets that yielded higher interest rates.

Carry trades can be profitable when the interest rate differential is large and the exchange rate stable. However, as the world saw on August 5 after the Bank of Japan raised interest rates — and indicated that further increases were possible — carry trades can also be risky. As the yen strengthened against the US dollar, investors sold off their higher-yielding assets and repaid their yen-denominated loans, leading to a global market selloff.

Legal considerations for global investing

Global investors must understand and comply with various securities regulations across different jurisdictions.

Some countries restrict foreign investment to protect national interests, promote domestic companies and maintain control over critical sectors of the economy. For example, China requires government approval to invest in certain sectors like telecommunications. India also imposes restrictions on foreign investment industries like defense, which is subject to government approval and is limited to a maximum foreign equity ownership of 74 percent.

Other industries are subject to special regulations that could impact operations and profitability. For example, pharmaceutical companies must navigate multiple rounds of testing and obtain approvals from various regulatory bodies, resulting in a lengthy process to bring a drug to market. While success can lead to substantial profits, these regulatory hurdles can also pose risks to potential investors.

Income tax regulations are another important area for investors to consider when participating in international markets. In the US, the Internal Revenue Service considers some foreign investment vehicles, typically foreign-based mutual funds and ETFs, as Passive Foreign Investment Companies (PFICs). The government body has implemented rules and regulations to prevent US taxpayers from deferring taxes owed from those investments. It’s crucial to know whether a stock is classified as a PFIC, because it can result in additional tax and reporting requirements.

The Canada Revenue Agency requires Canadian taxpayers to report their foreign investment income, including dividends, interest and capital gains from foreign investments. Canadian taxpayers with foreign investments may be subject to withholding taxes, a percentage of earned income from an investment that’s withheld from the investor and remitted to the tax authority where it was earned. However, Canada has tax treaties with many countries that can help mitigate withholding taxes, including Australia, Japan, Malaysia, the UK, Singapore and the US.

Many countries issue foreign tax credits to offset taxes on their foreign-source income and prevent double taxation, with specific rules and terms differing between countries. Controlled Foreign Corporation rules apply to larger stakeholders or those making direct investments in foreign companies or real estate.

Investor takeaway

Whether or not you’re a seasoned investor, understanding the dynamics of global investing, and key considerations like the risks and advantages of dabbling in international stocks, is crucial to making informed decisions and potentially reaping the rewards of a diversified portfolio.

Securities Disclosure: I, Meagen Seatter, hold no direct investment interest in any company mentioned in this article.

This post appeared first on investingnews.com

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