Most American investors begin their venture into the world of investing by investing in domestic stocks, in other words stocks of companies based in the USA. And this is natural, for these are the companies with which they are most familiar.
Interestingly, whether through direct investment or via mutual funds or ETFs, some portion of these investments likely involves U.S. Multinationals. These are companies based in the U.S. but who actually generate very large portions of their revenues outside the U.S. As an example, if you look at page 15 of the Coca-Cola Q1 2015 financial results, you will notice that only $5.1 billion of their $10.7 billion of operating revenues were in North America, meaning that the remaining $5.6 billion, or more than 50%, were outside the U.S.A.
It might surprise you to realize, though, that U.S. stocks represent only 30% of the total value of global markets. That means there is a far bigger picture to look at. This is the world of truly foreign companies; those based in various countries around the world and doing business in those countries, perhaps with no connection at all to the U.S. It is these that we will be discussing in this article.
Why Invest in Foreign Stocks?
Basically, the answer comes down to two reasons; Growth and Diversification.
Growth – In some ways, there is a similarity between the relationship of a large dividend-paying company vs. a smaller growth company, and the relationship between the U.S. and many other countries. The dividend-paying company is typically in a mature, developed business. It offers stability and regular dividends. The smaller growth company, in contrast, offers greater potential for significant expansion but combined with a higher level of risk because its business is not as well established or developed. In other words, there is more that could go wrong. Similarly, the U.S. is a very developed country, with a developed infrastructure and reasonably high standard of per-capita income. Smaller foreign countries, in contrast, are at varying points along this spectrum. They may have much infrastructure to develop, and a significant portion of their population to bring up to the standards that Americans would consider “middle-class.” Therefore, these countries offer the potential for greater growth. With this, though, comes added risk factors which will will discuss below.
Diversification – Because foreign companies operate in different countries, and using different currencies, their returns can often move in different directions than the U.S. The fancy phrase for this is that they often lack correlation. So, a portfolio with exposure to foreign stocks may provide a measure of stability at times that the U.S. market is declining.
Risk Factors of Foreign Investing
Foreign economies can be broken down into two categories: developed and developing (or emerging).
In general, a country is considered developed if it has a highly-developed capital market, competent and serious regulatory agencies, and high levels of per-capita income. Perhaps the best way to get an idea of the type of countries that fit this criteria is to look at the Top 10 countries represented in the Vanguard FTSE All-World ex-US ETF, designed to provide exposure to an index which tracks the entire world outside the borders of the U.S. (Ticker Symbol: VEU):
|Click to Enlarge|
Emerging economies, on the other hand, tend to be characterized by higher levels of economic, political, or social instability, lower per-capita income, and still-developing infrastructure. To get an idea of what countries fit this criteria, let’s now look at the Top 10 countries represented in the Vanguard FTSE Emerging Markets ETF , designed to provide specific exposure to an index which tracks only emerging markets outside the borders of the U.S. (Ticker Symbol: VWO):
|Click to Enlarge|
You might have noticed something interesting. In the first picture, I highlighted China in yellow. This is because it was the only country considered an emerging market that, due to its size, still made it into the Top 10 countries in the world-wide ETF offered by Vanguard.
In varying degrees, then, risk factors can include:
Currency Risk – Due to political, economic and other factors, the currency of a given country may not be as stable as the U.S. Dollar. For example, as I write this article, Greece is considered to be at risk of defaulting on its debt obligations and possibly facing threat of removal from the European Union. This is causing a level of turmoil in the Euro. Even in much less serious circumstances, varying conversion rates between the local currency and U.S. Dollar can cause the returns from foreign investments to either rise or fall.
Political Risk – Some developing countries may be relatively new to capitalism. They may or may not have a democratic form of government, or adequately guarantee human rights and the rights of workers and investors. Certain governments may even be at risk of overthrow and the resulting chaos and even anarchy.
Information Risk – Though progress has been made in this area, countries may have differing accounting and financial reporting standards. Some even curtail the use of, or censor, social media, making the acquisition of accurate and trustworthy information more challenging.
How ETFs Can Help
To borrow a phrase I use in my article Introduction to ETFs, “In large part, this question can be boiled down to one word; diversification.”
Clearly, these risks can be at least somewhat mitigated by having one’s investment in foreign stocks spread out over a very large range of companies and, even more, countries. To give you some idea of the power of ETFs, at the time of this writing the Vanguard FTSE All-World ex-US ETF, featured above, holds some 2,492 stocks, with measurable weightings in at least 45 countries. 81.2% of its holdings are in developed countries, with the remaining 18.8% in emerging markets. To go a step further, 73.4% of the funds assets are in the Top 10 countries I featured in the picture above.
If you wish to get a little more specific, you can also use ETFs to target specific geographic areas (i.e. Europe or Asia) and even countries. All of this, of course, will be based on your personal convictions and willingness to take on varying levels of risk.