Investors can easily exhibit signs of “home country bias”–the tendency to favor stocks from one’s own country. But wagering on international markets can be an important way to diversify and gain exposure to companies benefiting from rapid growth. And while American companies tend to pay higher dividends, investors may find attractive valuations abroad.
Since the 2008-2009 financial crisis, U.S. stocks have trounced foreign equities. The forces behind this trend have been easy Federal Reserve monetary policy, impressive U.S. corporate earning growth, and jaw-dropping rallies by a handful of mega-cap technology stocks.
But financial markets have a tendency to revert to their long-term averages–a concept known as mean reversion. And starting in 2021, money flows into overseas stock funds picked up, a sign that investor preferences are already shifting. However, foreign stocks also pose significant risks: such as local instability, differing reporting requirements, and volatile growth.
Here’s a closer look at foreign stocks and a guide to how to invest in them:
Pros & Cons of Foreign Stocks
Advantages of Investing in Foreign Companies
The U.S. stock market is the biggest in the world, accounting for a little more than half of the $95 trillion global equity market. But just because the U.S. market is the biggest, that doesn’t mean it’s the fastest growing or holds the best value. Here are some of the benefits of investing in international companies:
• Valuations: A staggering bull market in U.S. shares has left companies richly valued relative to foreign companies. For instance, the cyclically adjusted price-to-earnings ratio for the S&P 500 stood at 29.5 times in November 2020, while for the MSCI All-Country World Index, it was 18.3 times, according to Bloomberg data.
• Economic Growth: The U.S. stock market is outsized relative to its economy. While U.S. shares account for 56% of the global market, as a national, it only makes up 15% of global gross domestic product. Buying overseas stocks can be a way to participate in the rapid growth that many regions could see as more of their population joins the middle class.
• Geographic Diversification: Foreign-stock investing allows investors to hedge some U.S.-specific risks, by investing in the economies of other countries.
• Sector Diversification: The U.S. stock market is overwhelmingly concentrated in tech or tech-linked companies, with the 10 biggest stocks in the S&P 500 making up close to 30% of the index.
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Risks of Investing in Foreign Stocks
While there are many reasons to invest in international markets, these investments also come with risks that will surprise investors who are accustomed to domestic markets.
Volatile Growth: While overseas countries can post faster-paced growth than the U.S., that expansion can be jumpy. The International Monetary Fund said in April 2021 that while the U.S. was likely to experience a red-hot recovery after the Covid-19 economic downturn, emerging-market countries may lag behind and experience a more sluggish rebound.
Political or social instability: Depending on the country where they invest, an investor may have to grapple with the possibility of revolution, war or economic collapse.
Reporting Requirements: Not every market is rigorous in the transparency and reporting it requires from the companies on its public markets. That can make it hard to get the full story of what’s happening with an investment. Securities regulation as a whole varies from country to country.
Liquidity: International stocks trade in smaller markets, and certain markets may lack a large amount of buyers and sellers that could make the market efficient. That makes it more likely prices of assets will move with buy or sell orders.
Currency Risk: If a country’s currency sinks relative to the U.S. dollar, then a U.S. investor will lose a portion of the gains in any stocks that are traded in that currency. In the case of a foreign stock traded in the U.S., the currency of which that company does business will have a bearing on how U.S. investors view the company’s earnings.
Higher Fees: commissions and other trading costs related to international stocks are much higher than they are for domestic stocks. That translates into higher fees for a fund, or higher brokerage commissions if the investor buys and sells those stocks directly.
Recommended: What Are Liquid Assets?
How to Trade Foreign Stocks in the U.S.
International-Stock ETFs and Mutual Funds
Most investors who want more exposure to overseas markets will want to consider a mutual fund or an exchange-traded fund (ETF).
Investors based in the U.S. aren’t allowed to invest in mutual funds that are domiciled in other countries. That leaves U.S.-based funds that trade foreign securities. Those funds are usually categorized as either “global” or “international. ”
They sound interchangeable, but they have one big difference. Global funds own securities from all over the world, including the U.S. International funds, on the other hand, invest only in securities from countries outside the U.S.
Both global and international mutual funds include actively managed funds, where a portfolio manager and a team of analysts pick the securities in the fund. They offer professional investing in unfamiliar lands, but often come with high expense ratios.
And there are also funds and ETFs that invest in indexes. The wide array of indexes and the explosion of ETFs allows investors to use these tools to invest in very specific regions, countries and sectors within those countries and regions.
An ETF can also allow investors to buy quick exposure to the broader international markets. For example, an index fund or ETF that tracks the MSCI World Index would give an investor access to equities in 23 developed countries.
Recommended: The Pros and Cons of Thematic ETFs
What Are American Depository Receipts (ADRs)
Investing directly in overseas securities is where things get a little more complicated. One popular way to own international stocks is to buy American depository receipts (ADRs).
Many foreign companies use ADRs to raise capital in U.S. markets. Each ADR represents some number of underlying shares of the company’s stock, and trades throughout the day. Global Depository Receipts (GDRs) are another way to buy shares in overseas companies. But they are typically traded on the London Stock Exchange and Luxembourg Stock Exchange.
But there are also ways for investors to directly purchase foreign stocks. One is to open a global account with a domestic broker, and most large brokerages offer this option. If investors are targeting opportunities in a specific country, they can open an account with a local broker in that country.
Different Types of International Markets
International stocks as a broad category may be enough for an investor who sees them as a simple way to diversify their overall equity holdings. But different international investments have widely varying risk/reward profiles.
Investing in Developed Markets
The first category of countries to invest in are so-called “Developed Markets.” These are countries with industrial and post-industrial economies and mature capital markets, such as England, Australia, and Japan. As a general rule, these offer similar growth and risk to the U.S.
Investing in Emerging Markets
The next category is “Emerging Markets,” which are still growing and modernizing to an industrial or information-driven economy. They include places like Thailand, Russia and South Korea. Investments in these markets may come with much bigger opportunities for growth. But they also carry the risk that comes with often-political climates, along with other risks unique to the countries they’re in.
Investing in Frontier Markets
The third category consists of “Frontier Markets,” which are also known as pre-emerging markets. Companies in these countries, such as Argentina, Bangladesh and Kenya, come with even larger opportunities, but even more risk, including political and currency instability, as well as very little regulation.
The Takeaway
International stocks offer diversification, unique opportunities, and can help investors hedge any U.S.-specific risk. But they also bring their own set of costs and risks.
The question of how much of an investor’s total assets should be allocated to international stocks depends on the investor’s expertise, risk tolerance and long-term goals. But some investors have said they allocate 30% of equities internationally, a level that allows for diversification while recognizing higher volatility.
Recommended: What Is Asset Allocation?
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