Looking beyond U.S. borders
In the past, American investors have focused largely on U.S. markets. However, that is rapidly changing. Although U.S. equities still represent the single largest segment of the global stock market, more than half of the world's total stock market capitalization lies outside the United States, and economic growth rates outside the United States have in some cases exceeded that of the United States. As a result, investors have increasingly begun to explore diversifying their holdings beyond U.S. borders. In the past, experts often recommended allocating no more than 10-20 percent of an investor's overall portfolio to international funds. However, with the growth of global markets, many experts now suggest an even higher percentage can be appropriate given the right circumstances.
Because economies in different parts of the world may move in different cycles, international diversification may help moderate the overall volatility of an investor's portfolio. However, on their own, overseas investments also can be more volatile than domestic investments because they are subject to special risks not associated with U.S.-only investments.
Mutual funds can be a particularly useful way to participate in overseas investments, for several reasons:
- Easy access to overseas markets--A mutual fund may be able to purchase securities that are either difficult or impossible to purchase individually. For example, to invest in a wide variety of securities that aren't traded on U.S. exchanges, you might have to set up accounts in many different countries and deal with multiple foreign currencies.
- Greater research capabilities--The availability and quality of investor information can vary greatly from country to country. For example, countries may have accounting and regulatory standards that are different from those of the United States. A mutual fund manager may have a greater ability to research and screen overseas securities than an individual investor might.
- Diversification--Like any mutual fund, a fund that invests overseas may offer greater diversification at a lower cost than you might be able to obtain on your own. It can diversify across not only many different securities but many different countries. However, diversification alone does not guarantee a profit or ensure against a loss.
It's important to remember that globalization has brought a greater correlation between the performance of U.S. and overseas markets than there used to be. That in turn has reduced to some extent the diversification benefits of investing overseas.
There also are tradeoffs to be considered that are unique to investing overseas:
- Geopolitical risk--Political and economic instability in a country can affect investment values, not only in that country but in its global trading partners. Factors such as nationalization of specific industries, currency measures, tax law revisions, and legislation that affects international trade all can have an impact on global investments. And in the case of international or global bond funds, a country's budget deficit or bond rating can affect the value of its bonds, and in turn any bond fund that holds them.
- Currency fluctuations--The value of holdings denominated in a foreign currency will fluctuate with the exchange rate between that currency and the U.S. dollar (see below).
- Liquidity risk--International markets may have much lower trading volumes than U.S. markets, and individual purchases may have a greater impact on an individual security and any funds that hold it.
- Market risk--Overseas markets can be more volatile than U.S. markets, and may require a longer holding period and greater risk tolerance to maximize the likelihood of a positive return.
- Higher costs--Because of the unique operational requirements of running an overseas investment, funds that invest overseas (including index funds) may have higher expenses and administrative fees than domestic funds. These added costs reduce your overall return and increase any losses.
- Differences in financial reporting.
Check on whether any domestic funds you already hold also include overseas holdings, and if so, what percentage of the overall portfolio they represent. Some mutual funds classified as domestic funds may have a surprisingly large percentage in overseas companies, particularly if a fund's name doesn't limit it geographically.
Remember that many large multinational U.S. companies now earn a large percentage of their revenues overseas. A mutual fund that invests in those companies can be another way to benefits from overseas growth.
You can invest internationally with either actively managed mutual funds, in which a manager selects specific countries and securities in which to invest, or by using an index fund that tracks one of the many indexes covering either a broad selection of countries or a more narrowly focused group.
Overseas funds come in many flavors, and terminology varies among investment firms. One company's international fund may be another's global or world fund. Be sure to obtain and read a fund's prospectus and carefully consider its investment objectives, risks, fees, and expenses before investing. And don't forget that just because it invests overseas does not mean that a foreign stock or bond fund is exempt from the same risks involved with any stock or bond mutual fund. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful.
Currency fluctuations: To hedge or not to hedge?
U.S. investors may not get the same rate of return on a foreign investment as locals do. That's because exchange rates between the currencies of various countries are constantly changing. If a fund has holdings that are denominated in a foreign currency, those changes can affect the value of a portfolio when the position is translated into U.S. dollars. The value of those holdings may increase if that currency strengthens against the dollar; conversely, when the dollar rises, securities denominated in other currencies may lose value (at least for U.S. investors).
One factor to consider in your decision-making is whether a fund hedges its currency exposure. Some funds that invest overseas use forward contracts, currency futures, and other derivatives to try to limit the impact of those currency fluctuations on the value of their holdings. Others do not, hoping that any weakness in the dollar will increase the value of the fund's assets for U.S. investors. Still others may hedge only part of their currency exposure.
Whether you prefer an unhedged fund to try to benefit from possible currency fluctuations or one that uses hedges to manage the risk they involve, bear in mind that hedging currency exposure will increase a fund's expenses and therefore reduce its total return. And don't forget that currency movements are notoriously hard to predict; some of the best investors in the world have seen their expectations go awry.
In addition to the general tax issues that apply to most mutual funds, overseas funds are subject to foreign income tax. Since these funds invest in foreign companies, they pay income tax to the countries in which those companies are based. Those taxes are generally passed along to shareholders, and your fund must notify you of your proportionate share of them. Don't worry that you'll find yourself writing individual checks to the revenue departments of foreign governments; foreign tax is deducted from the fund's assets and reported on the fund's yearly Form DIV-1099. This foreign tax is in addition to any U.S. taxes you might owe on dividends and/or capital gains distributed by the fund. However, you may be able to claim a deduction or a foreign tax credit on your federal income tax return for foreign tax paid. Consult a tax advisor for details.
An international fund (also known as a foreign fund) seeks investment opportunities--either stocks or bonds, depending on the type of fund--primarily outside the United States. Some of these opportunities arise because many solid top-performing companies are located in overseas countries such as Germany or Japan. Other opportunities arise because the economies of many countries or regions are poised for rapid growth. In either case, a diversified international fund can help manage country-specific risks.
If you're considering an international fund, it's especially important to find out where it invests. For example, some international funds exclude non-U.S. North American countries (Canada and Mexico); some don't. An international fund may focus on developed countries only, or mix both developed and emerging markets.
These funds invest in securities whose issuers are located throughout the world, including the United States. As a category, they are generally viewed as the most stable of the overseas funds because they have the most diversified menu of countries from which to choose. Also, they tend to invest in large, well-established companies, though some also may have a portion of their assets in emerging markets.
Global funds take advantage of the increasing global interdependence of the business world. Many U.S. companies receive a large proportion of their revenues overseas, and the United States typically represents the largest single market for foreign companies. A global fund is designed to make the most of whatever markets around the world hold the most promise at any given time. The percentage of fund assets invested in U.S. stocks at any given time could vary widely, depending on how favorably U.S. companies compare with foreign companies. Typically, global funds invest the majority of their assets in foreign stocks.
One of the greatest strengths of a global fund is its potential reach. Because it invests all over the world, a global fund manager has greater flexibility; if one market or region is underperforming or is expected to underperform, a manager can shift assets to other parts of the world. (A global index fund has less short-term flexibility, since its securities selection will change only when the index does.)
Country and regional funds
Rather than investing across many different companies around the world, some funds specialize in one country or geographic region. For example, certain countries may have natural resources that can benefit from a commodities boom in oil or iron ore. Others may be attractive because of their large populations and rapid economic development. Still others might offer a relatively strong currency or stable political structure.
A single-country fund invests primarily in the equities of companies of a specific country. In some cases, however, country funds also invest in securities of companies outside the single country if those securities are expected to benefit from growth in the target country. A regional fund focuses on a particular part of the world, such as Europe or the Pacific Rim, buying the stock of companies that are headquartered in the region or that derive most of their business there.
Despite the important differences between them, country funds and regional funds share certain characteristics. For example, both limit their holdings to a narrower field than other global and foreign funds. In addition, most single-country or regional funds invest in equities rather than bonds, and normally pursue the investment objective of above-average capital appreciation (rising share price). Depending on where it invests, a single-country or regional fund also might be considered an emerging markets fund (see below).
A fund that invests in a single country or region can help an investor make a narrowly focused investment without taking on the risk of buying an individual foreign stock. For example, a fund focused on a country whose economy is thriving because of its abundant natural resources might be used to try to capitalize on a commodities boom. Single-country funds also allow an investor who is familiar with a particular country or area to take advantage of that knowledge.
- Potentially greater risk than other overseas funds--Obviously, investing in a single region involves less diversification than investing around the world; investing in a single country means still less diversification. Investments in a single country are subject to political and economic conditions there. Even if there is no political or economic turmoil, there are always garden-variety changes in law and policy. For example, countries have been known to change tax policies and nationalize industries that are important to their economies. As a result, these funds should be regarded as a relatively small portion of a portfolio, and are normally not suitable for unsophisticated, risk-averse investors or those who need a reliable source of current income (few of these funds pay regular dividends).
- Increased exposure to currency fluctuations--Unless the fund hedges its currency exposure or the local currency is pegged to the dollar, the exchange rate between a single currency and the dollar can mean greater currency risk.
Emerging markets funds
These funds invest in countries or regions that have less fully developed economies, a population with a relatively low per-capita income, and/or a shorter history of participation in modern global markets. For example, despite their size and growing economic clout, China and India are both considered emerging economies because they are still undergoing substantial economic development and reform. Latin America, Eastern Europe, China, India, and the Far East all are considered to be emerging markets.
An emerging markets fund may focus on a broad representation of emerging markets or a narrow selection. For example, BRIC (Brazil, Russia, India, and China) countries have generated widespread interest among investors because of their growth rates and sizable populations, and some funds invest exclusively in these four countries.
Emerging markets hold great potential for investors who are comfortable with the greater level of risk involved. However, despite their promise, there is still a relative amount of uncertainty--especially in the short term--about whether and when these markets will ultimately realize their potential, and what crises might occur along the way. As a result, emerging markets funds are considered the riskiest of the overseas funds.
- Growth potential--Growth rates in emerging regions and countries have begun to exceed those of the developed world, according to the CIA World Factbook. And some emerging markets have such enormous populations that many investors see the emergence there of a middle class with spending power as the next great global growth story. According to the CIA World Factbook, four countries alone--Brazil, Russia, India, and China--represent more than 40 percent of the world's population. That's a lot of untapped potential consumer demand for goods and services.
Additional portfolio diversification--As with regional or single-country funds, emerging markets funds may offer a different level of portfolio diversification than international funds, which may rely more heavily on developed markets and therefore may more closely parallel conditions in the United States. For example, commodities feature prominently in many emerging economies, which may therefore respond somewhat differently to global economic conditions than countries focused on manufacturing or services.
- An emerging markets fund is likely to be more volatile than global or international funds, which may be dominated by the securities of larger companies in relatively developed countries
- Many emerging markets have had a history of political and economic instability
- The currencies of emerging market countries historically have been especially subject to volatility and the potential impact of inflation
Contact us with questions or comments.
Frances Gardner, CFP®, CDFA® , CFEd®
Gardner Wallace Financial Solutions