At any given moment, the best-performing stocks aren’t always for the companies closest to home.
American investors have certainly seen that in 2015. The S&P 500 index has edged up just 2 percent so far in 2015. Meanwhile, Germany’s benchmark DAX index has risen some 12 percent, while Japan’s Nikkei 225 index is up nearly 16 percent. Thus, many investors consider exposure to foreign companies and economies an essential part of a balanced portfolio.
But investing in foreign companies carries unique risks that investors should consider carefully before placing a buy order. Below, we’ve listed a few things globally-minded investors should consider.
How You Can Go Global
Investors who want to add international exposure to their portfolios have several options, including mutual funds, exchange-traded funds (ETFs), and individual stocks.
Mutual funds and ETFs that invest in foreign companies gain overseas exposure in a variety of ways and at various levels. Some invest in both U.S. and foreign companies, while others stick exclusively to overseas firms. Some funds choose stocks from the wide array of companies that are based overseas and trade on international exchanges, while others focus on a particular country or region. Sometimes, an ETF can mirror a mutual fund from the same issuer. Either fund can provide exposure to a targeted basket of securities.
Investors may also choose to buy individual shares of an overseas company. A common way to do this is to purchase American Depositary Receipts (ADRs), which are traded in dollars on U.S. stock exchanges or over-the-counter (OTC) markets. The receipts give the holder the right to buy the foreign stock, but most people simply hold the ADRs as they are.
Seasoned travelers know to pay attention to the currency rates of the countries they are visiting. That’s a good practice for the global investor too.
A company’s products can become more or less attractive to foreign buyers based on how valuable the domestic currency is compared to foreign currencies, and that can have a big impact on a company’s bottom line—and thus, perhaps, its stock price.
ADRs are priced in dollars, but that doesn’t mean they are immune to changes in the currency of the company’s home country. ADRs largely track the movement of the foreign shares to which they are tied, and a large change in the exchange rate between the company’s local currency and the dollar will likely trickle down into the price of the ADR.
And even if an international mutual fund appreciates over a period of time, an investor could still see depreciation if the local currency declines sharply in value against that of the investor’s home country.
Currency changes can also greatly impact your return when it comes time for dividend payments. When an investor gets a dividend payment, it is converted from foreign currency into dollars.
If an investor is looking at a total dividend payout from a Mexican company of 40,000 pesos, they would probably prefer a dollar to be worth 400 pesos, which would give them a $100, versus 4,000 pesos, which would leave them with just $10.
When someone invests in a foreign company, they also invest in the local economy, which can be greatly impacted by the local politics of the country where the company is based.
In an increasingly interconnected world, a crisis can send capital flowing rapidly out of one economy and into another. Investors should be well versed in the political and economic risks they’re buying into, particularly if investing in an individual foreign company or a country-specific fund.
Even if you invest in a company in good health, you could find your investment hurting if macroeconomic events—such as a government’s inability to pay its debts—rock the market.
Costs: Read the Fine Print
Investing in foreign companies frequently comes at a higher cost than investing stateside.
The depositary banks that issue ADRs often charge fees for their services and will deduct those fees from dividends and other distributions paid on your shares, according to the U.S. Securities and Exchange Commission.
And fees and expenses such as commissions and annual operating expenses are often higher for internationally-focused mutual funds and ETFs than U.S.-focused funds.
Investors should make sure they understand the fees that mutual funds and ETFs charge, as even small differences in these fees can add up over time. Investors can use the Financial Industry Regulatory Authority’s free Fund Analyzer to compare different internationally-focused funds before investing.
Diversification can help manage concentration risk in a portfolio. For those who have carefully studied the risks and potential costs of investing in foreign companies, adding geographic diversity may be a smart way to add variety to a portfolio dominated by one country or region.