This article is not intended to be legal, tax, or investment advice. Investing in foreign stocks involves legal, tax, and investment risks. Before investing in foreign stocks, you should consult with your legal, tax, investment, and other advisers.
Guest Contributor: Nick de Peyster
The more stock opportunities you see, the greater the chances that you will find a superior investment. With that in mind, why limit yourself to investing in a single country, even a country with as many investment opportunities as the United States?
If you like investing in U.S. stocks, for example, you can multiply your opportunity set by a factor of three or four by remaking yourself into a global stock investor. If you want to become a global stock investor but are uncertain how to move forward, this guide may help you.
Selecting the countries
As a new global stock investor, you should start by selecting the countries in which you will invest. We suggest you focus initially on the following variables: transaction costs, counterparty risk, and regulatory risk.
Transaction costs vary significantly across the various stock markets. In general, the costs of trading stocks in foreign stock markets exceeds the cost in the United States. However, in a number of cases the costs are not too different. Typically, the lowest-cost stock markets are the ones that have automated their trading and trade settlement systems. One should also consider the cost of converting currencies, which can range from negligible to exorbitant.
If your investment strategy tends to involve lots of buying and selling of stocks, you should focus on the stock markets with the lowest trading costs. Otherwise, the cost of trading could erode some or all of your expected investment profits. On the other hand, if your investment approach tends to favor holding investments for the long-term, the cost of getting into or out of an investment may be trivial.
In other cases, the market structure may involve floor brokers and the exchange of physical stock certificates. Trading in such markets may cost much more than one would expect in the United States.
Buying or selling a stock involves the exchange of cash for shares (“settlement”). Counterparty risk is the risk that the party to your trade does not live up to its obligations.
Counterparty risk depends to a great extent on two issues:
- How much time is allowed to elapse before the trade must be settled
- Is the exchange of cash and stock simultaneous or asynchronous?
The longer it takes to settle a trade, the greater the counterparty risk. Ideally, you want to reduce the amount of time the trade remains unsettled because doing so reduces the opportunity for the counterparty to go bankrupt and not honor its side of the trade.
An asynchronous exchange of cash and stock is riskier than one that is simultaneous. In some countries, when you buy a stock, you send your cash now but you receive your shares later. If, in the meantime, the other party goes bankrupt, you may have nothing.
The U.S. regulatory and market structure seems to do a good job of reducing counterparty risk for the investor who trades through U.S. stock exchanges. One cannot assume the same if one invests in foreign stocks. There may substantial delays between the movement of cash and the movement of shares.
While not perfect, the regulatory framework in the United States offers meaningful protections for the consumer.
The situation may be different in some other countries. Some foreign stock regulators do not have as well-developed a regulatory system. Even where the regulations are comprehensive, the funding to administer and to enforce the regulations may not be. Regulations that exist only on paper may have no value.
One should look for brokerage account insurance. In the United States, brokerage accounts are insured against certain types of theft and similar losses. Foreign stock brokers may not protect you in this way.
Before becoming a global stock investor, one must decide which countries offer a favorable operational environment. This means you should do your due diligence on transaction costs, counterparty risk, and regulatory risk.
Another approach is to trade globally through a U.S.-registered broker. Just because a stock trades in Tokyo does not mean that one must have an account with a Japanese broker. More than a few U.S.-registered stock brokers offer the opportunity to trade in Tokyo. Using a U.S.-registered broker does eliminate the need for due diligence, but it may reduce some of the risks. Most reputable U.S.-registered brokers will have due diligence processes in place to protect their customers.
Choosing a broker
You should choose a broker that offers services that meet your needs. In doing so, you should consider both the range of offerings and the likely cost of doing business. If you are an American, you must also consider that many foreign financial institutions will not let you open an account due to onerous U.S. financial regulations.
RANGE OF OFFERINGS
Unfortunately, we have yet to find a single broker that offers access to the top 40 stock exchanges. For U.S.-registered brokers, the broker with the broadest offering covered 25 countries. The lowest cost broker covered 15.
With a U.S.-registered broker one can gain access to the stock markets of many of the economically advanced countries. However, some countries are not available, including Taiwan, South Korea, and Israel. U.S. brokers also do not offer access to several less-developed countries, including Hungary, Egypt, Russia, Indonesia, Malaysia, Thailand, and the Philippines. If one wants to invest in stocks in these countries, one must open an account with a foreign stock broker. Foreign stock brokers may conduct their businesses under a regulatory scheme that does not afford robust consumer protection.
As we discussed earlier, trading foreign stocks tends to cost more than trading in the United States. Sometimes it’s a little more, sometimes considerably more, depending on the trading and trade settlement procedures.
In addition, stock brokers have their own charges, which can range from minimal to eye-watering. It is to your advantage to shop around. Consider not just the commissions on trading stocks but the cost of converting currencies, as well. In the U.S., we have seen the total cost of a trade (stock commissions and currency commissions, plus other fees) at one firm exceed the low-cost rival by many multiples.
Depending on your investment strategy, trading costs may or may not matter. If your strategy requires lots of buying and selling, you may want to work with the lowest-cost broker. A strategy that focuses on holding for the long-term may not be as sensitive to costs.
Types of accountants
After choosing the countries and brokers, you should consider how to fund an account. The types of accounts vary according to your nationality. For Americans, should you use personal funds or a retirement account? Would it make sense to use a trust account, if you have one? If you have another structure (for example, a corporation or a partnership), would that make sense?
As you might expect, the answer depends on your circumstances, the costs you are willing to bear, and the tax uncertainty you are willing to tolerate. Most of the issues relate to tax and tax paperwork.
Based on our research, we believe using a personal account offers the best chance of minimizing the tax and tax paperwork inconveniences. If, as an American, you select the right countries, your foreign tax compliance could be as simple as filing an extra form or two. We suspect the same applies to people from a number of other countries.
Investing through some legal entities may create problems. Certain types of legal entities (for example, trusts) are not universally recognized. Tax unpredictability follows lack of status. Paperwork burdens may be greater, as well.
Americans should know that their individual retirement accounts are legal entities. Section 408(a) of the Internal Revenue Code states: “… the term ‘individual retirement account’ means a trust created or organized in the United States for the exclusive benefit of an individual or his beneficiaries …” [emphasis added].
How to find foreign stock ideas
Finding attractive investment opportunities in foreign stocks can be challenging. The research infrastructure is not as well-developed as in the United States. Some would call this an inconvenience. We consider it an opportunity because it limits competition.
The Financial Times offers some predefined screens, plus the ability for one to create a custom screen. Their screens may be simple, but they offer enough to reduce one’s research list to dozens of stocks, rather than thousands.
Some stock exchanges store financial information about the stocks they offer for sale. They may offer some elementary screening capabilities to help the investor quickly identify the more promising opportunities.
There are not many investment newsletters focused on global investing in stocks. We had to create our own because we couldn’t find any that met our needs. The Global Deep Value Letter focuses on undervalued stocks with good quality. This letter is designed for the classic “value” investor.
Researching foreign stock
How can you learn more about a particular foreign stock that appears to be a promising investment?
We would start with the company’s website. Many companies with publicly traded shares have a website that includes an Investor Relations section. If not, we would turn to the local regulator. In many countries, the regulator is the Ministry of Finance, a separate securities regulator of the stock exchange itself.
Except for the Anglophone countries, foreign websites and financial filings will likely be in a foreign language. Using a Chrome Browser, you can translate a foreign language website into your native language by clicking on the translate button in the right corner of the browser’s address bar. The translations are of mediocre quality, but one can get an idea of what the original document says.
If one is comfortable relying on secondary sources, one can use a website like Bloomberg or Financial Times, both of which maintain extensive files on thousands of publicly traded companies.
Trading foreign stock
Trading foreign stocks is a little different from trading U.S. stocks.
Not surprisingly, foreign stocks are priced in a foreign currency. This means that prices in currencies that have a low value may appear high. Very few U.S. stocks trade for more than $2,000 per share. But in Japan many stocks trade for more than 2,000 Yen per share. After accounting for the exchange rate, such Japanese stocks trade for an equivalent of roughly US$20 per share — an amount that seems rather ordinary.
DIFFERENT TRADING HOURS
Stock markets maintain different hours. In the U.S., stock markets are open from 9:30 a.m. to 4:00 p.m. (ET) — a full six and a half hours. Other markets may have dramatically different hours. The Tokyo Stock Exchange has two sessions of 150 minutes, one in the morning and one in the afternoon. There is a one-hour break between the two.
TIME ZONE DIFFERENCES
You should also consider time zones. The global stock investor should be prepared to trade at odd hours. For example, an East Coast U.S. investor is about half a day behind Tokyo. Thus, to trade Tokyo on Friday morning, one trades in New York on Thursday evening. From the U.S. East Coast, trading in Europe happens in the early morning.
Countries may have different types of symbols for stocks. The U.S. uses alphabetical symbols, and many other countries have adopted the same practice. Japan uses numbers. Other countries use a combination of letters and numbers.
MINIMUM SHARE LOTS
Some countries impose minimum share lots for trading. This means you cannot buy a single share. You have to buy the minimum lot — maybe 100 shares, maybe 1,000.
Transactions and exposures
Foreign currency is an issue not just in the buying and selling of foreign stocks. If the stock does not rise or fall, but the currency moves, your net worth (expressed in your local currency) will move solely because of the movement of the currency. If that isn’t acceptable, you will have to manage your currency exposures. There are three tools for doing so:
- Exchange currencies
- Borrow currencies
- Hedging currencies using futures
Currency conversion is the simplest tool for managing currency exposure. If you want to buy a Japanese stock in Tokyo, exchange enough of your local currency into Yen, buy the stock, and then settle the trade.
If you like a stock but do not like the currency in which it is traded, you can hedge by taking out a foreign currency margin loan. Not all brokerage firms offer such loans, but some do.
The idea here is that you have in the stock a foreign currency asset. The margin loan (in the same currency) is your foreign currency liability. If you have done it correctly, the asset and liability are offset, reducing your net foreign currency exposure to zero. You still have exposure to the performance of the stock.
When you sell the stock, you use the foreign currency proceeds to pay off the foreign currency margin loan. If all goes well, there is money left over after the loan is extinguished. Otherwise, you have to make up the difference.
Margin loans are not for inexperienced investors. For one thing, they involve interest charges. You must maintain adequate collateral in your account to avoid a margin call. Margin calls are bad, as they are usually associated with significant losses.
HEDGING CURRENCIES USING FUTURES
Futures are another tool for managing currency exposure. When you enter into a foreign currency futures contract, you agree to receive or to deliver a specific amount of foreign currency at some time in the future.
If you have a “long” futures position, your position is similar to owning the foreign currency itself. If you have a “short” position, it is not unlike having borrowed the currency.
If you like a foreign stock but do not like the currency in which it trades, you could consider “shorting” some futures for delivery of the foreign currency in question.
Futures trading involves commissions, though the commissions tend to be modest.
Currency exposure management
Ownership of a foreign stock does not require one to assume all the risk of the foreign currency.
If the prospects for a currency look good, you could consider having an unhedged position. This means taking on the full exposure to the currency. You could benefit if the currency rises in value, and you could be harmed if the currency falls in value. If the prospects for a currency do not look good, you could consider hedging the risk using the tools we described earlier.
How do you decide whether a currency has good or poor prospects? While you can never know for sure what will happen to the price of a currency, we look at three variables: price trend, interest rates, and purchasing power parity.
We believe that trends tend to persist. Thus, if a currency has been rising in value for the past several months, we think it has somewhat better chances of continuing to rise in the near-term. The same also applies for downward trends: We believe currencies that have lost value over the past several months are somewhat likely to continue losing value in the near-term.
We believe that the currencies of high interest rate countries are more attractive than the currencies of low interest rate countries, assuming no difference in credit risk. In measuring interest rates, we mean the interest rates on the highest quality short-term government debt.
Differences in credit risk must be considered. Differences in interest rates often can be explained by differences in risk. You should be careful to compare apples to apples.
You should also consider the effects of inflation. High interest rates sometimes reflect high rates of inflation. You can calculate the real interest rate by deducting from the interest rate the rate of inflation. Currencies offering higher real interest rates may perform better than currencies offering lower real interest rates.
PURCHASING POWER PARITY
Another approach to valuing currencies is to consider what each currency can buy. Does US$100 go as far in Europe as it does in America? If it goes further in Europe, then the euro may be better to own than the U.S. dollar.
Taxes and paperwork
Owning foreign stocks may create some new taxes and is likely to create new paperwork. The tax and paperwork compliance issues depend on the countries involved.
THE NATURE OF TAX COMPLIANCE
In our view, tax compliance involves two separate issues:
- Actual tax liabilities
In a number of countries, it is not enough for you to pay your taxes. You must also file the correct paperwork on time. Failure to do either may result in fines, and unpaid fines can accumulate rapidly.
FOREIGN TAX COMPLIANCE
We believe that paying the tax is the easy part. For many of the countries we have researched, the foreign governments tax only the investment income, with the tax withheld from dividend payments. In many countries, capital gains are entirely exempt from foreign tax.
Paperwork requirements are less clear. Some governments do not want the foreign investor to file forms if the investor’s income tax liabilities have been covered through the divided withholding system. For them, they have already been paid and have no interest in incurring the cost of processing the paperwork.
Other governments feel differently. As a global stock investor, you must familiarize yourself with the paperwork requirements of the countries in which you invest. It is beyond the scope of this guide to cover all the intricacies. My book, Investing in Foreign Stocks, covers this information for a large number of countries.
U.S. TAX COMPLIANCE
U.S. taxpayers who own foreign stocks face some unique paperwork requirements. Foreign tax credits generally enable the taxpayer to reduce their federal tax liabilities dollar-for-dollar by the amount of investment income tax paid to foreign governments. Claiming the credit usually requires filing a form with one’s return.
U.S. taxpayers must be aware of FATCA and FBAR. These are disclosure forms: The federal government wants to know about your foreign financial accounts and certain types of foreign investments. You do not want to make mistakes with these forms. Non-compliance penalties are astonishing.
A qualified U.S. tax accountant can help you with these compliance responsibilities.