Investors who want to increase the diversification and total return of their investment portfolios are usually advised to enter international assets. Many people are unwilling to accept this suggestion.
In fact, investors will increase three major risks when entering international investment. Understanding what they are and how to mitigate these risks may help you decide whether going global is worth the risk and the potential rewards.
1. Higher transaction costs
The biggest obstacle to investing in international markets is increased transaction costs. Yes, we live in a relatively globalized and interconnected world, but transaction costs still vary greatly depending on the foreign market you invest in. Brokerage commissions in the international market are almost always higher than US interest rates.
- The cost of external transactions is often much higher.
- Currency fluctuations are another level of risk in foreign transactions.
- Liquidity can be an issue, especially when investing in emerging economies.
In addition to higher brokerage commissions, additional fees specific to the local market may also be charged. These may include stamp duty, taxation, taxation, clearing fees and transaction fees.
For example, the following is the general situation of each transaction of a single purchase of Hong Kong stocks by US investors:
|types of fee||cost|
|Brokerage commission||HKD 299|
|All||HKD 299 + 0.108%|
Based on the exchange rate on August 1, 2020, the cost of each transaction is approximately US$38.60.
In addition, if you invest through a fund manager or professional manager, the fee structure will be higher than usual.
For managers, the process of recommending international investments involves spending a lot of time and money on research and analysis. This may include hiring analysts and researchers familiar with the market, as well as other professionals with expertise in foreign financial statements, data collection, and other administrative services.
Investing in American Depository Receipts (ADR) is an option for those who want to avoid the higher costs of purchasing foreign assets.
For investors, these costs will be reflected in the management expense ratio.
One way to reduce the cost of international stock transactions is to invest in American Depository Receipts (ADR). Depositary receipts, such as stocks, are transferable financial instruments, but they are issued by Bank of America. They represent the stocks of foreign companies, but they are traded as US stocks without foreign exchange fees.
ADR is sold in U.S. dollars. This makes their investors vulnerable to currency price fluctuations. In other words, if you buy the ADR of a German company and the dollar depreciates against the euro, the value of the ADR will decrease accordingly. Of course, it is two-way, but there are risks.
2. Currency fluctuations
When investing directly in a foreign market (rather than through ADR), you must first convert US dollars into foreign currencies at the current exchange rate.
Suppose you hold foreign stocks for one year and then sell them. This means that you must convert foreign currency back to U.S. dollars. This may help or hurt your returns, depending on the movement of the U.S. dollar.
It is this uncertainty that frightens many investors.
Financial professionals will tell you that the solution to reducing currency risk is to simply hedge your currency risk. Available instruments include currency futures, options, and forwards. These are not strategies that most individual investors are willing to use.
A more user-friendly version of these tools is the currency exchange traded fund (ETF). Like any ETF, they have good liquidity and accessibility, and are relatively simple.
3. Liquidity risk
Another inherent risk in foreign markets (especially emerging markets) is liquidity risk. This is the risk of not being able to sell investments quickly at any time without facing major losses due to political or economic crises.
Ordinary investors have no simple way to guard against liquidity risks in foreign markets. Investors must pay special attention to foreign investments that have or may become illiquid when they want to sell.
There are some commonly used methods to assess the liquidity of assets. One method is to observe the bid-ask spread of the asset over time. Compared with other assets, non-current assets will have a larger bid-ask spread. Narrower spreads and high trading volume usually mean higher liquidity.