A Guide To Investing In European Equities

Investing in European equities can be an attractive option for investors looking to diversify their portfolios. Europe is home to many of the world's top companies in sectors such as healthcare, industrials, automotive, and luxury goods. While the US market has outperformed European stocks in recent years, there are reasons to be optimistic about the future of European equities.

In this guide, we will explore the different ways to invest in European stocks, including ETFs, mutual funds, and direct shares. We will also discuss the benefits and drawbacks of each approach, as well as provide an overview of the European stock market and its performance.

Exchange-traded funds (ETFs)

ETFs are a type of investment fund that can be traded on an exchange like a stock. They are designed to track a particular index, sector, commodity, or asset, and their value is derived from the performance of the underlying asset. This means that when you invest in an ETF, your returns will closely follow the performance of the target market or index.

There are currently 25 ETFs available that allow you to invest in a broad range of European stocks. These ETFs track various indices, including the FTSE Developed Europe, MSCI Europe, STOXX® Europe 600, and Solactive GBS Developed Markets Europe Large & Mid Cap. The total expense ratio (TER) of these ETFs ranges from 0.05% p.a. to 0.30% p.a., making them a cost-effective way to invest in European equities.

Some popular Europe-focused ETFs include:

• SPDR Portfolio Europe ETF
• Xtrackers MSCI Europe Hedged Equity ETF
• Vanguard FTSE Europe ETF
• IShares Core MSCI Europe ETF
• JPMorgan BetaBuilders Europe ETF
• WisdomTree Europe SmallCap Dividend ETF
• SPDR EURO STOXX 50 ETF

These ETFs provide exposure to a diverse range of European stocks, giving you access to large-cap, mid-cap, and small-cap companies across various sectors and countries.

When investing in European equities through ETFs, it's important to consider the currency risk associated with the fluctuating exchange rate between the US dollar and the euro. Additionally, as with any investment, make sure to do your research and understand the risks and potential returns before investing.

American Depository Receipts (ADRs)

ADRs offer US investors a way to purchase stock in overseas companies that would not otherwise be available. Foreign companies benefit from ADRs as they enable them to attract American investors and capital without the hassle and expense of listing on US stock exchanges.

ADRs are denominated in US dollars and are priced and traded in dollars, cleared through US settlement systems. They are issued by US banks that purchase shares on a foreign exchange. The bank holds the stock as inventory and issues an ADR for domestic trading. They can be listed on the New York Stock Exchange (NYSE), the Nasdaq, and over-the-counter (OTC).

There are two basic categories of ADRs: sponsored and unsponsored. A sponsored ADR is issued by a bank on behalf of the foreign company, with the two parties entering into a legal arrangement. The foreign company usually pays the costs of issuing the ADR and retains control, while the bank handles the transactions with investors. Sponsored ADRs are categorised by the degree to which the foreign company complies with Securities and Exchange Commission (SEC) regulations and American accounting procedures.

Unsponsored ADRs are issued without the involvement, participation, or permission of the foreign company. Multiple unsponsored ADRs for the same foreign company could theoretically be issued by different US banks, and these different offerings may offer varying dividends. Unsponsored ADRs never include voting rights and trade only over the counter.

ADRs are also categorised into three levels, depending on the extent to which the foreign company has accessed US markets. Level I ADRs are only found on the OTC market and have the loosest requirements from the SEC. Level II ADRs can be used to establish a trading presence on a stock exchange but cannot be used to raise capital. Level III ADRs are the most prestigious and allow issuers to establish a substantial trading presence and raise capital in US financial markets.

ADRs are priced similarly to the underlying shares on a one-for-one basis, a fraction of a share, or multiple shares of the underlying company. The depositary bank will set the ratio of US ADRs per home-country share to appeal to investors.

Investing in an ADR may incur additional fees, such as a custody fee charged by the depositary bank to cover the cost of creating and issuing an ADR. Dividend payments are net of currency conversion expenses and foreign taxes, and holders of ADRs may need to seek a credit from the IRS or a refund from the foreign government's taxing authority to avoid double taxation on capital gains.

ADRs are easy to track and trade, available through US brokers, denominated in US dollars, and offer portfolio diversification. However, investors may face double taxation, have a limited selection of companies, and incur currency conversion fees.

Direct shares

This is the most direct method, although it is often the least familiar to American investors who have only owned domestic securities. For example, if you want to own shares of a large chocolate company in Switzerland, the specifics of how you go about buying shares will differ based on the brokerage firm you use to execute your trades.

A brokerage should help you exchange U.S. dollars for Swiss francs for settlement, and it will also charge a spread and inform you of the final execution price and the commission amount. The commission amount will usually involve an additional commission for the local broker in Switzerland with which your broker has a relationship.

When the shares appear in your brokerage account, they will be shown without a ticker symbol (or with a ticker symbol that cannot be traded online). The shares will also be shown in the U.S. dollar equivalent, not the actual quoted price in Swiss francs.

As a result, they can appear to fluctuate wildly, even if they have not changed in quoted value on the Swiss stock exchange. The custodian (which is probably also your broker) will tell you what the stock would be worth if you sold the position and converted the resulting Swiss francs to U.S. dollars.

Any dividends received in Swiss francs are going to be automatically converted to U.S. dollars and deposited in your brokerage account as a net spread (in light of the currency conversion). Foreign taxes to the government of Switzerland will also be withheld, usually at a rate of 35%.

To avoid this, you would have to go through the trouble of filling out a specific set of paperwork that claims your right as an American citizen, under a tax treaty between the United States and Switzerland, to opt for the lower 15% foreign dividend tax withholding rate. In rare cases, your custodian might be able to show the quoted value of the shares in Swiss francs and allow you to hold multiple currencies in your account so that the dividends also arrive in Swiss francs.

One drawback to this investing method is that it requires investing at least several thousand dollars per transaction. You may not technically need thousands of dollars to buy European stocks this way, but the added commissions and expenses will take a chunk out of your profits, and you can minimize their impact by trading in bulk.

You may also want to consider prioritizing buy-and-hold investments to minimize the currency exchange costs that make switching between positions expensive.

Mutual funds

Understanding Mutual Funds

Benefits of Mutual Funds for European Equities

• Diversification: Mutual funds typically hold a diverse range of stocks from different sectors and countries within Europe, reducing the risk of a single stock or market impacting your investment significantly.
• Professional Management: Fund managers and analysts conduct in-depth research and analysis to select stocks, construct portfolios, and make investment decisions on your behalf. This can be especially beneficial when navigating the complex European market, which includes various countries, currencies, and regulatory frameworks.
• Ease of Investment: Mutual funds offer a simple way to invest in European equities without the need for extensive knowledge about the market or individual stocks. They handle the trading and portfolio management aspects for you.
• Risk Mitigation: The diversification and professional management inherent in mutual funds help reduce overall investment risk. Additionally, the funds' investment in larger, more developed European markets, such as Britain, Germany, and France, provides a degree of stability.

Popular Mutual Funds for European Equities

When considering mutual funds for European equities, it's essential to review their investment objectives, track record, fees, and holdings. Here are some popular options:

• T. Rowe Price European Stock Fund (PRESX): This fund has an expense ratio of 0.97% and seeks long-term capital growth by investing primarily in common stocks of companies located or operating primarily in Europe.
• Brown Advisory - WMC Strat Eurp Eq Fd: This fund seeks total return by investing in equity securities issued by companies established or operating in Europe.
• Janus Henderson European Focus Fund: With total assets of $414.42 million, this fund focuses on long-term capital appreciation by investing primarily in equities of European companies.
• JPMorgan Europe Dynamic Fund: With total assets of $519.28 million, this fund seeks total return from long-term capital growth by investing in equity securities of companies with a significant presence in Europe.
• Invesco EQV European Small Company Fd: With total assets of $173.67 million, this fund focuses on long-term capital growth by investing at least 80% of its net assets in securities of small-capitalization companies located in Europe.

Final Thoughts

Currency risk

Exchange rate fluctuations can have a significant impact on the returns of your overseas investments. For example, if the US stock market gains 5% while the US dollar weakens by 5% against the pound, a UK investor will see a total return of 0% (-5% local return plus -5% dollar-to-pound return). Conversely, if the US stock market loses 5% while the dollar strengthens by 5%, the UK investor will see a total loss of 10% (-5% local return plus -5% dollar-to-pound return).

The impact of currency risk is particularly relevant for investors who need to sell their investments in the short run, as exchange rate fluctuations can be volatile. Longer-term investors, however, may even benefit from currency risk, as studies show that its impact tends to decrease as time horizons lengthen.

To manage currency risk, investors can consider the following strategies:

• Increasing asset allocation to your own currency area: Investing in local equities, property, and bonds can reduce currency risk. However, this may result in less diversification, especially if the local market is heavily skewed towards certain sectors or global companies that earn most of their revenue abroad.
• Currency-hedged ETFs: These products use financial contracts to offset the effects of exchange rates on fund returns. While they can neutralise currency risk, they also cancel out any gains from rising overseas currencies.
• Diversification: Splitting your assets across different currencies can help manage currency risk. Holding assets in multiple currencies can provide a hedge against the long-term decline of a single currency. Additionally, safe-haven currencies like the US dollar and euro tend to have a negative correlation with equity prices, providing a potential cushion during market downturns.
• Long-term investment: As exchange rate fluctuations tend to have less impact on long-term equity returns, investing for the long term can help mitigate the effects of short-term currency volatility.
• Partial hedging: Investors can choose to hedge currency risk on the bond side of their allocation while maintaining exposure on the equity side, or investing in local government bonds.

It's important to note that currency risk is just one aspect of investing in European equities, and investors should also consider other factors such as economic, political, regulatory, and business conditions.

Frequently asked questions