Aside from the meltdowns of the financial markets in the past decade, arguably not much has garnered more attention than international and emerging market investing.
It's on the minds of our clients, advisors and the manufacturers of everything from exchange-traded funds to separate accounts. Just as individual investors' long-term record of performance is nowhere near the index averages, investing globally can easily become another buy-high-sell-low debacle in your clients' portfolios if not done well.
Investing overseas has been a hot topic for years. Opportunities abound, from the rapid expansion of capitalism and consumerism in emerging markets, to the creation of the European Union and the rising value of the euro compared to the U.S. dollar. In 2011, investments abroad dominated the headlines once again, but for a very different reason - the numerous risks they pose.
As you think about the realities of foreign economies and how you may add an international flavor to your portfolio, implementation takes courage. Before we get down to specifics, let's go over a few basics. When the term international investing is being used, that typically refers to investments that are devoid of any U.S. holdings. When the term global investing is used, that typically includes foreign as well as American holdings.
There are risks that come with investing globally that are somewhat unique compared to those we deal with here in the U.S. The average American investing abroad doesn't even consider most of these potential deal-killers. The general risks that always exist, in addition to the timely headwinds enumerated above, include: currency, political instability, liquidity, transparency and inflation. Each one of these risks is fairly material in its own right, but if you get a few of them working in harmony against you, your investment can get crushed.
Currency risk is a lot deeper than most investors understand. Naturally, we have concern if the value of any currency fluctuates wildly when you are invested in assets of that nation. But when invested in foreign assets whose local currency takes a nosedive, it's not necessarily bad for you because it is possible that the U.S. currency will take an even bigger plunge.
It is also possible to own foreign investments that are denominated in foreign or U.S. currency. That is a decision frequently over the head of most investment advisors, and only well understood by financial analysts with significant experience in foreign investing. Perhaps this is only the first of many reasons why CPA advisors are well advised not to rely on the popular press and fake it as a portfolio manager. The wise advisor will seek specialized help with these decisions from third-party asset managers or international specialists, and will implement accordingly.
CHAOS AND LIQUIDITY
Political instability seems to be the way for many foreign nations - especially when you get into the less developed nations around the world. Here in the U. S., we view events like 9/11 as an isolated, extraordinary event. Thankfully for us, they are. But head east to Africa, the Middle East or the Far East emerging countries, and it is a daily concern and way of life. Can you even remember a week in which there wasn't news about rigged elections, dictators, and assassination plots in some remote spot on the globe? It seems rather obvious, but it may not be good for your portfolio to be invested in countries where people are killing each other for a bottle of water.
Liquidity is also an issue, and should be considered from several perspectives. First, you should know that world stock markets are not always open for what we may consider normal trading hours. In the U.S., markets are traded five days a week for 6.5 hours per day. But the Karachi Stock Exchange, denominated in Pakistani rupees, is only open for 4.5 hours per day. The Egyptian Stock Exchange, denominated in the Egyptian pound, is only open for four hours per day. Most foreign country stocks can be purchased through U. S. firms that have relationships with traders on the floors of these foreign exchanges, but that puts yet another middle man in the way of your assets going to work for you, and potentially adds another layer of fees. Once again, my advice is to be aware of this weakness, but leave this decision to your favorite foreign investment consultant.
Liquidity again comes into play when you want to make a trade in something that is thinly traded. Without adequate trading volume, pricing and therefore the value of your holding is suspect. Exactly what is your investment worth if there have only been a few trades over the past month in that position? You may not really know until you try to sell. If the holding is in one client account, there may not be an issue. But if that thinly traded holding is across many of your clients' accounts, a simple block trade may depress the selling price.
TRANSPARENCY AND INFLATION
Transparency in the U. S. has gone from a buzzword a few years ago to the way we do business in the financial world. Other countries, however, have not declared transparency as their way of doing business. Not only is transparency important with respect to costs, but it's an issue with financial reporting, insider trading, management experience, mergers and acquisitions, trade secrets, and corporate business plans in general. Most seasoned foreign investors are so callous to news from certain countries that they spend millions in additional due diligence to enhance their decision-making ability.
Inflation is a risk everywhere. But here in the U.S. we have the Federal Reserve, whose No. 1 priority is to control inflation. We do it through interest rate manipulation and the monetary supply. Developed foreign nations also take some hand at controlling inflation, yet their methods can differ materially from those of the U.S. Their calculation of inflation is likely to be derived in a different manner than the two methods used here in the U.S. For you and I, understand that simply comparing inflation rates published by one country and another may be like comparing peer review to movie reviews.
Moving away from the developed foreign nations, inflation sometimes looks more like a temperature reading. Double-digit or triple-digit inflation happens every year somewhere in the world, and it can change as fast as the temperature, too. You do not want to get washed away in another country's tsunami of inflationary changes and volatile economic policies.
Hopefully, these risks haven't overshadowed the opportunities available by investing globally. If you're still game, the only questions left are what countries, what asset classes and how much.
When I started as an investment advisor in the 1980s, it was common to hear investment consultants speak in terms of a 5-percent-to-10-percent position in foreign equity investments. Foreign holdings were viewed as non-correlating assets that could either help preserve wealth or add some juice to your investment returns.
Today, it again appears to be less correlated than it was a few short years ago, and many economists have lowered their expectations, and their holding percentage in foreign investments. Some economists, perhaps a bit more extreme or radical, have made even bolder predictions and suggest either a majority or virtually none of your portfolio in foreign investments. Personally, I'd not abandon the space entirely.
As significant as the rise in attention that foreign investing is receiving today are the asset classes represented. We have gone way beyond foreign equities only, and today investors can invest in foreign fixed income, real estate, equity, specialty asset classes, and specific countries.
As you look at the performance of the broad foreign markets over the past decade or so, it appears as if foreign investing has filled in the middle of the performance pack. Not consistently great, and not consistently bad, but rather a combination of good years and bad years that have collectively averaged in the middle of the pack. This raises the question of whether advisors and their foreign specialists would be better served if they added a bit of a tactical approach, with the goal of participating in as much of an up cycle as possible and avoiding the down cycle. Perhaps this is easier said than done, but there are both specialists who offer this and research services that will offer tactical or technical opinions on markets in general and on specific positions.
Before you use this article or any other general research about foreign investing, make sure that you consult with a specialist. By way of example, I am very impressed by the gross domestic product numbers and the potential growth that seem imminent for many emerging markets. But I also know that these markets frequently overheat and become priced well above what many analysts would consider a desirable entry point. So using top-down research with respect to these markets may not be enough. It seems like everyone else believes this growth story too, and demand for these investments had driven up the prices to the high end of the range. However, they took a pretty hard hit when European issues began to dominate the news.
That's why I would hire a solid investment consultant to help design portfolios that dig a lot deeper than the big picture and long-term economic trends.
And I suggest you consider the same.
John Napolitano, CFP, CPA/PFS, is chairman and CEO of U.S. Wealth Management, in Braintree, Mass.
-- This article first appeared on Accounting Today.