Foreign Mutual Funds: Invest Or Avoid?

Investing in foreign mutual funds can be a great way to diversify your portfolio and gain exposure to international markets. However, it's important to consider the benefits and risks involved. One of the main advantages of investing in foreign mutual funds is that it allows you to invest in a broad range of international companies across different countries and sectors, which can help to reduce the overall risk of your portfolio. Additionally, foreign markets can provide higher growth rates and above-average returns compared to domestic markets. However, there are also some drawbacks and risks associated with investing in foreign mutual funds, including currency fluctuations, political events, and complex tax reporting requirements, especially for American investors. Therefore, it's essential to carefully evaluate your investment goals, risk tolerance, and the specific funds you are considering before deciding to invest in foreign mutual funds.

Foreign mutual funds can help diversify your portfolio

Foreign mutual funds and exchange-traded funds (ETFs) are a straightforward way to access stocks from outside the US market. They are a great way to give your money a "passport to overseas markets" and increase your portfolio's diversification.

By investing in an international mutual fund or ETF, you gain access to hundreds or even thousands of foreign securities. Markets outside the US do not always rise and fall at the same time as the domestic market, so owning pieces of both international and domestic securities can level out some of the volatility in your portfolio. This can spread out your portfolio's risk more than if you owned just domestic securities.

For instance, during the ""lost decade" for US equities from 1999 to 2009, the US stock market posted a meagre compound annual growth rate of 1.7%. However, international developed markets yielded a more robust 4.1% annualised return, while emerging markets delivered a stellar annualised return of 13.7%.

Foreign mutual funds and ETFs offer a simple alternative to dealing with American depositary receipts (ADRs) or currency conversions. Vanguard recommends that at least 20% of your overall portfolio should be invested in international stocks and bonds. However, to get the full diversification benefits, consider investing about 40% of your stock allocation in international stocks and about 30% of your bond allocation in international bonds.

It is important to note that investing in foreign mutual funds may come with additional reporting requirements and tax implications, especially for US citizens. The US tax code categorises non-US registered mutual funds as Passive Foreign Investment Companies (PFICs), which are taxed punitively. PFICs must be reported annually on US Tax Form 8621, which requires complex accounting and is time-consuming.

Foreign markets may outperform domestic markets

Foreign stocks can be competitive with their domestic counterparts, and investors who do not invest in them may be missing out on more than half of the global market. After over a decade of underperformance compared to US equities, foreign stocks are finally having their moment. From the end of October 2022 to the end of June 2023, the equal-weighted MSCI EAFE Index, which tracks developed markets abroad, was up more than 20%, while the equal-weighted S&P 500 was up just 6%.

International large-company stocks are projected to return 7.6% annually over the next 10 years, compared with just 6.1% annually for US large-company stocks. Therefore, investors should probably have more exposure to international stocks than they currently do.

Foreign markets can also act as a buffer for investors against potential stagnation and can potentially reap above-average returns. For example, while the US stock market posted a meagre compound annual growth rate of 1.7% from 1999 to 2009, international developed markets yielded a more robust 4.1% annualised return. Even more impressive were the returns from emerging markets, which delivered a stellar annualised return of 13.7%.

Foreign markets may also outperform domestic markets because they do not always rise and fall simultaneously. Owning both international and domestic securities can level out some of the volatility in your portfolio and spread out your portfolio's risk.

Foreign stocks can be purchased via American depository receipts (ADRs)

ADRs are priced and traded in US dollars, and cleared through US settlement systems. They are denominated in US dollars, which means investors can avoid the direct risks associated with fluctuations in currency rates. However, investors may incur currency conversion fees when investing in ADRs.

ADRs are issued by a US bank that purchases shares on a foreign exchange. The bank holds the stock as inventory and issues an ADR for domestic trading. They can be listed on major US stock exchanges such as 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 on behalf of the foreign company, with the bank and the business entering into a legal arrangement. The foreign company usually pays the costs of issuing an 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.

An unsponsored ADR has no direct involvement, participation, or even permission from the foreign company. In theory, several unsponsored ADRs for the same foreign company could be issued by different US banks, and these different offerings may also offer varying dividends. Unsponsored ADRs never include voting rights and trade only over the counter.

ADRs provide an easy, liquid way for US investors to own foreign stocks and offer a means to diversify their portfolios. However, there are some drawbacks and risks. There is a limited number of foreign companies listed, and some ADRs may not comply with SEC regulations.

ADRs may also involve double taxation, both locally and abroad. Holders of ADRs realise any dividends and capital gains in US dollars, but dividend payments are net of currency conversion expenses and foreign taxes. To avoid double taxation, American investors would need to seek a credit from the IRS or a refund from the foreign government's taxing authority.

Additionally, liquidity for some ADRs may be low, which can affect bid/ask spreads and eat into profits. The institutions that issue ADRs may also charge quarterly or annual pass-through fees, which can further erode returns.

Foreign ordinaries allow investors to access a wider array of international companies

Investing in foreign mutual funds can be a great way to access a wider array of international companies. By investing in foreign ordinaries, investors can gain exposure to a broader range of companies located outside of the United States. This is especially beneficial for those who want to invest in specific international companies that are unavailable as American depository receipts (ADRs).

Foreign ordinaries are foreign stocks that can be traded on the US over-the-counter market. This means that investors can access international companies without having to trade on a foreign exchange or open a foreign brokerage account. While there are usually higher commissions for trading foreign ordinaries compared to ADRs, the fees tend to be lower than buying foreign stocks directly through local markets.

Another benefit of investing in foreign ordinaries is that trades are conducted in US dollars, eliminating the need to deal with currency conversions. This can simplify the investment process and reduce the impact of currency fluctuations on investment returns.

However, it is important to note that foreign ordinaries traded on the over-the-counter market may have lower liquidity than those traded on local market exchanges. This can lead to greater price volatility and wider bid-ask spreads. Additionally, trades may be subject to foreign transaction fees, and broker assistance is typically required for trading over the counter, which can result in higher fees.

When considering investing in foreign ordinaries, it is essential to carefully weigh the benefits against the drawbacks. Investors should also ensure they have a comprehensive understanding of the tax implications and reporting requirements associated with foreign investments, as they can be complex and differ significantly from those for US-based investments.

Direct foreign investments can be made by opening a specialised global account

Investing in foreign mutual funds can be a great way to diversify your portfolio and tap into the growth potential of international markets. However, before diving into this investment option, it's important to understand the benefits, risks, and specific ways to invest in foreign companies.

One common way to invest in foreign companies is through a specialised global account offered by brokers. This option, known as direct foreign investment, allows investors to trade international stocks in their local currencies and access a wider selection of individual stocks compared to hunting for their U.S. versions. For example, the Schwab Global Account™ enables trading in over 30 countries, with real-time online trading in 12 markets, including Australia, Hong Kong, and Japan.

There are several benefits to opening a specialised global account for direct foreign investment:

• Wider Investment Selection: You can access a broader range of international stocks by trading directly on local exchanges, rather than limiting yourself to U.S.-listed foreign companies or American Depository Receipts (ADRs).
• Active Involvement: Direct foreign investment allows investors to be actively involved in the management of the foreign company, which is particularly appealing to those seeking substantial influence over decision-making.
• Enhanced Portfolio Diversification: By investing in foreign companies, you can reduce the risk of volatility in your portfolio. Markets outside the United States don't always rise and fall simultaneously with the domestic market, so owning a mix of international and domestic securities can help spread out the risk.
• Access to High-Growth Markets: Investing in foreign companies provides access to high-growth markets and industries that may not be available in your domestic market. This allows you to tap into the growth potential of dynamic economies and sectors.

However, there are also some drawbacks and considerations to keep in mind:

• Currency Risk: When investing in foreign companies, your investment value is subject to fluctuations in currency exchange rates. If the U.S. dollar strengthens relative to the local currency, the value of your investment may decline.
• Regulatory and Political Risks: Each country has its own regulations, and investing in foreign companies means navigating multiple sets of rules and policies. Political events and policy changes in the host country can also impact your investment.
• Transaction Costs: Trading in a global account typically incurs foreign-currency-conversion fees and trading commissions, which can eat into your profits.
• Limited Liquidity: Some foreign stocks may have lower liquidity, affecting bid/ask spreads and potentially impacting your ability to buy or sell large quantities of stocks quickly.
• Tax Implications: Investing in foreign companies can trigger complex tax reporting requirements and punitive taxation. For U.S. taxpayers, foreign mutual funds are often categorised as Passive Foreign Investment Companies (PFICs), leading to complex accounting and time-consuming tax filings.

In conclusion, direct foreign investment through a specialised global account offers investors the opportunity to access a wider range of international stocks and gain more control over their investments. However, it's important to carefully consider the benefits and drawbacks, especially the potential risks associated with currency fluctuations, regulations, transaction costs, liquidity, and taxation.

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