Table of Contents
There have been various techniques used over the past couple of years to diversify the risk and realize greater returns. Asset managers have used a variety of techniques to ensure that the portfolio they create for the investor is according to their risk-return preference. Most asset managers in the US, prefer to invest domestically due to barriers that are involved in investing abroad. Obviously, there is a protocol that needs to be followed when one is considering investing abroad, but due to the Globalization there are various investment vehicles that can be used to surpass these barriers to invest abroad and yield higher returns without taking on additional risk.
Some of the most common techniques used while optimizing a portfolio are i. spreading a portfolio amongst different investment vehicles. ii. diversifying within each type of investment (e.g vary by sector, region, market capitalization etc.) iii. diversifying in securities that vary in risk (companies with different market capitalization). Focus of this paper is to investigate the benefits and drawbacks of foreign investments and various investment vehicles that are offered while investing abroad. This paper will also describe the simulation that was conducted and talk about the data, the model and the final result of that simulation. Difference between Foreign Portfolio Investment and Foreign Direct Investment As far as investing abroad is concerned, there are mainly two types of investment, Foreign Portfolio Investment (FPI) and Foreign Direct Investment (FDI).
Foreign direct investment (FDI) is a term used to denote the acquisition abroad of physical assets, such as plant and equipment, with operational control ultimately residing with the parent company in the home country. The intent with FDI is typically to help make a business more profitable and generate a return on investment It may take several different forms including: I. the establishment of a new enterprise in an overseas country; either as a branch or as a subsidiary II. the expansion of an existing overseas branch or subsidiary III. the acquisition of an overseas business enterprise or its assets. On the contrary, Foreign Portfolio Investment is the purchase of international securities that can be easily bought or sold. The intent with FPI is generally to invest money into another country’s stock market with the hope of generating a quick return. Although, FDI and FPI both involve putting money into a foreign country, the two investment options differ significantly. With FDI, investors can exercise control over their investments and are typically actively involved in the management of the companies they invest in.
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On the other hand, FPI, investors do not get a say in how their investments give out return because they’re not actively participating in the management or operations of the companies they’re invested in. Another big difference between FDI and FPI is that investors with an FDI approach are generally looking for a long-term investment. Because it can take time to build up a company, those who go the FDI route usually wait a while before they can enjoy capital gains. With FPI, investors tend to take a shorter-term approach and can receive earnings on the investments earlier on. Lastly, FPI is generally considered to be a more liquid and less risky investment option than FDI. Because foreign securities are traded regularly, an investor looking to liquidate a foreign portfolio can sell off assets like stocks or bonds with relative ease, compared to liquidating a company/business in a foreign company.
Benefits of International Portfolio
As mentioned above, FPI is a great short-term investment. There are numerous advantages that comes with investing in securities abroad. A few of them are mentioned below. Diversifying Markets in the US have become very competitive since more and more businesses offer similar services. The way the global stock market works make it possible for the same factors at a given time will have different effects to the markets located at different countries. This means that if you have stocks in different countries, you will have the opportunity to experience less volatility over your entire portfolio. Securities abroad might have negative covariances with each other/domestic securities which will help the investor to branch out and manage the risk involved with the portfolio. Countries that have greater growth rate could not only help realize greater capital gains but also help with diversifying the risk.
Greater Choice
In the list for the world’s biggest stock exchanges NYSE and NASDAQ take the 1st and the 2nd position with the market capitalization for $24,220 billion and $11,860 billion each. However other stock exchanges are not far behind with stock exchanges for Tokyo, Shanghai and London having a market capitalization of $6,288 billion, $5,023 billion and $4,596 billion respectively. Due to Home Bias, where people tend to invest domestically rather than diversifying internationally, investors have not taken full advantage of the benefits that are offered in foreign markets. The US houses only 17% of the world’s stocks. One of the biggest advantage of investing abroad is the sole option of having a variety of securities to choose from. This means that the investor can pick securities based on the specifics they want in a company (e.g. sustainability practices, philanthropy causes associated etc.) Since we live in such a connected world, it is very easy to obtain the financials of a company.
The investor can look for the exact type of P/E or Sharpe ratio that they want in a company to invest in. Benefit from Exchange Rate One of the biggest factors involved in FPI is the Exchange Rate, meaning the price of a nation’s currency in terms of another currency. Assuming an investor from the US invests $1000 in Tokyo Stock Exchange. According to the current exchange rate, the investor will be investing around ¥113,768 (1USD=113.77JPY). If the dollar weakens against the Yuan, it means that the investor will get more dividends/gains due to exchange rate difference. Therefore, investing internationally is a great way to realize gains, provided the currency is not too volatile. In another scenario, let’s say that the investor realizes a loss on their investment, a stronger dollar could help the investor, recover the loss (in USD).
For example, if we buy a stock and the stock falls by 10%, and in the meantime, the dollar appreciates by 20%, depending on the exchange rate, the loss and the gain could cancel each other out. Obviously, the opposite is true if the dollar strengthens against the dollar, which is described later in the paper. Drawbacks of International Portfolio On the contrary, investing abroad comes with its disadvantages. Some of them are mentioned below: Higher Transaction Costs The biggest barrier to investing abroad is the transaction costs. It varies from country to country but in general, it is more expensive for an investor to buy securities in a market different than their national country. In certain cases, it is required that the investor opens an international account where all the losses/profits would be debited/credited. Developed countries like China and the United Kingdom usually have few transaction costs compared to emerging countries like India.
Therefore making them more preferable compared to other emerging economies. One way around this disadvantage is purchasing American Depositary Receipts (ADR). Foreign Exchange Risks Foreign Exchange Risk is associated with fluctuations in a foreign currency relative to the U.S. dollar. For example, a foreign company may report 25 percent earnings growth, but if its local currency depreciates by 10 percent relative to the U.S. dollar, the real growth rate is just 15 percent when the profits are converted back into U.S. dollars. This sometimes causes the investment to take a hit and could be one of the many reasons why investors have a home bias.
However, business have found a way around this risk involved, which is that it may attempt to hedge some of its foreign-exchange risk by buying futures, forwards of the currency of the country they have invested in. This gives the investor some sort of protection from this kind of risk. Additional Risks Foreign investments are always risky because the political situation in some countries can change in an instant. The investor could suddenly find his investment in serious jeopardy due to several different reasons, so the risk factor is always extremely high. For example, Brazil nationalized part of its largest oil company — Petroleo Brasiliero — in a move that caused many investors to lose money. A subsequent corruption scandal involving the company pushed shares even lower. Some foreign markets trade at much lower volumes compared to the exchanges in the US. There could be fewer investing options, and the markets may not be open during all traditional business hours.
There are various ways an investor can invest internationally, using different Investment vehicles. Some of the most common ones are described below Investing vehicles Investing abroad can be tricky, but there are several instruments that can be used when it comes to investing abroad. These instruments may directly or indirectly hold securities in other countries. Buying these instruments or buying a share of these instruments may help gain the benefits of investing abroad. American Depositary Receipt (ADR) An ADR is a certificate that represents shares of a foreign stock owned and issued by a U.S. bank.
The foreign shares are usually held in custody overseas, but the certificates trade in the U.S. Through this system, many foreign-based companies are actively traded on U.S. equity markets. Holders of ADRs realize any dividends and capital gains in U.S dollars, but dividend payments in foreign currency are converted to U.S dollars. There are several risk involved in investing in ADRs. Firstly, although the investment is valued in dollars the returns are exposed to the fluctuation of foreign currency exchange rate. This increases the overall volatility of the financial return. Secondly, since the companies that offer ADRs are based out of U.S, this may cause problem when acquiring or disposing of the shares since the company is not popular in the U.S, therefore it is not ideal to hold ADRs for a short-term.
Lastly, the holding bank of the ADRs may incur expenses in managing the entire process, this cost is passed on to the investors and is usually deducted from the dividends. In contrast, there are several benefits that come with investing in ADRs. Firstly, holding ADRs can result in favorable currency conversion for the dividends. Secondly, access to emerging markets in another huge advantage, countries like China and India who have had a rapid increase in GDP have a fast-growing stock market which people in US can take advantage of. Lastly, investing in ADRs is like buying a domestic stock, therefore the convenience of having such a facility is great from an investors stand-point.
Mutual Funds
A mutual fund is a company that brings together money from many people and invests it in stocks, bonds or other assets. The combined holdings of stocks, bonds or other assets the fund owns are known as its portfolio. Each investor in the fund owns shares, which represent a part of these holdings. Lately, we have been seeing a lot Mutual funds which provide international exposure. Mutual Funds like Fidelity International Growth (FIGEX) and Vanguard Total International Stock ETF (VXUS) have shown tremendous growth and given big returns to its investors. Investing in Mutual Funds can come with its shortcomings. For example, investing in Mutual Funds means that you place your money in the hands of a professional manager, therefore the returns on your investment depends heavily on the skill and judgement of the manager.
Secondly, there are certain fees involved with investing in Mutual Funds, which can reduce the returns on the investment. On the other hand, Mutual Funds have their advantages. A single mutual fund can hold securities from hundreds or even thousands of issuers which diversifies the investment. Secondly, mutual funds can be bought and sold any business day thus providing investors with easy access to their money. Exchange-Traded Funds (ETF) An ETF is a type of a fund that owns underlying assets and divides ownership of those asset into shares, it is then traded on stock exchanges much like stocks.
An ETF can hold assets like stocks, commodities, bonds and even currencies. They are usually inexpensive, and easy to trade. One of the biggest type of ETFs traded on the stock exchanges are iShares, which are managed by BlackRock, world’s largest investment management corporation with $6.29 trillion in assets under management. Some of the most common ETFs with international exposure are iShares Core MSCI Total International Stock ETF (NASDAQ:IXUS), Schwab International Equity ETF (NYSEMKT: SCHF) and Vanguard FTSE Emerging Markets ETF (NYSEMKT: VWO).
