Last month we examined the case for international diversification in stock and bond portfolios, and reviewed currency risk, which can have a dramatic impact on the returns U.S. investors receive from international investments. This month in part two we focus on regulatory and political risks, and conclude by looking at investments you can use to effectively implement global diversification.
It’s easy to take it for granted, but the accounting and regulatory environment we enjoy in the U.S. provides investors with audited information, a system of financial oversight, and a (mostly) level playing field. While accounting and reporting standards in some other developed markets are comparable, they are by no means identical. Moreover, many capital markets, especially in developing counties, lack stringent regulation, consistent reporting standards, market liquidity and shareholder rights legislation. In some markets, loose or unconventional accounting standards make it very difficult to compare results among companies and industries; investment decisions made in these less-than-ideal environments can be very challenging.
Foreign governments routinely default on their bonds, devalue their currencies, and nationalize private companies. These are examples of political risks, and they can have dramatic and unexpected consequences for investors, ranging from a modest write-down in the value of an investment to a total loss without hope of recovery. Abrupt changes in government policy, terrorism or insurgencies are also factors to consider when investing, as well as regional, tribal or religious favoritism, cronyism and corruption, all of which are tolerated as normal business practices in many parts of the world.
Implementing a global portfolio
Your first decision should be to select an appropriate balance of stock investments, bond and fixed income, and short-term investments suitable to your age, income needs and tolerance for risk. The next step is to carve out a portion of these major asset classes for international investment. Twenty percent of your stock portion and 10-15 percent of your bond portion can be a good starting point. Here are some investment options.
If you want to purchase individual company stocks, you can buy actual shares of the foreign companies as sold on their home exchange, in their own currencies, although these shares, known as ordinaries, can be a little difficult to purchase and own. Many investors prefer to invest in ADRs, or American Depository Receipts. ADRs are specially issued share proxies that trade on U.S. exchanges like any other stock, and represent a specified number of the ordinary shares. The underlying ordinary shares are held in trust at a sponsoring bank. In most cases ADRs are as easily purchased as the stock of any U.S. company, and many multinationals, including firms like British Petroleum (BP) and Novartis (NVS) trade on U.S. markets as ADRs.
There are some real challenges to researching and evaluating individual foreign company shares; perhaps for this reason mutual funds, either traditional, exchange traded, or closed end, have been a particularly useful tool for investors looking beyond our borders. The broadest category of these is global funds, which have the latitude to invest in any country or region. International funds, on the other hand, invest strictly outside the U.S. (and sometimes Canada). There are also many single country funds, regional funds, and even funds that invest in a particular international sector; for example, global utilities or international real estate. IShares, a major sponsor of exchange traded funds, has lots of useful information on its website at www.ishares.com. You can also view traditional fund offerings in the international and global sectors on the websites of major no-load fund families like Vanguard, T. Rowe Price, and Fidelity.
While many international funds rely on fundamental research and economic forecasting, with plenty of latitude as to where and how to invest, there are also index funds for those who prefer this more diversified and lower cost strategy. The MSCI EAFE, or Morgan Stanley Capital International Europe Asia, and Far East Index, is probably the best known international index, although Dow Jones, Russell, and many other financial companies maintain global indices as well. The EAFE is market capitalization weighted, and provides representation in 22 developed markets outside the U.S. and Canada. The EAFE has a companion emerging market index; the two can be combined in your portfolio to give you a desired mix of international investments. The developed market index can be tracked using an exchange traded fund (symbol EFA), while the emerging market component can be tracked by an exchange traded fund (symbol EEM). It’s not possible to invest in the indexes directly.
One final note for yield investors: Be aware that many foreign countries withhold taxes on dividends paid to U.S. investors. These can reduce your effective yield. However, in many cases you may file with the IRS to take a tax credit on this withholding, effectively avoiding the double taxation of dividends.
Steven Weber and Gloria Harris are investment advisors for The Bedminster Group. The Bedminster Group provides fee-only investment, estate and financial planning services. The information contained herein was obtained from sources considered reliable, and does not constitute tax advice. Their accuracy cannot be guaranteed. The opinions expressed are solely those of the author and do not necessarily reflect those from any other source.