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Chap. 15 International Portfolio Investment

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Chap. 15 International Portfolio Investment Chap. 15 International Portfolio International Equity Investing Investment • 1. Offers more opportunities than a pure domestic portfolio: Nokia is a leading • Benefits of International Equity Investing cellphone produces. Asia is making high • International Bond Investing quality electrons and automotive products. • Measuring Total Return: the Addition of Potentially, China Telecom has a huge market. Currency Risk. • 2. International Diversification: Risk may be reduced through global diversification: other • Nov. 5, 2002 by William Pugh countries have different business cycles. When or if you need to sell to raise cash, the U.S. may be in a recession. International Equity Investing Japan’s Nikkei 225 compared with the S&P 500 • At the beginning of 2000, an American may not have thought global diversification was a good idea given the superior performance of the U.S. over the last decade. • We have suffered much since • At the end of the 1980s, the Japanese probably thought the same thing as their market had out performed others. • Since then, however, Japan’s market has fallen sharply, from about 38,000 points to as low as 8400. • Graph on next slide International Equity Investing International Equity Investing • Capitalization: stock price times number of • Certainly, investors in small countries should shares outstanding. globally diversify - if only to get more • What it would cost to buy every share in a diversification across industries. country’s stock market. (not really) • Developed markets: Include The USA, Canada, • United States: about 50% of world’s stock value. W. Europe, Australia, N. Zealand, and Japan. • Japan: about 15% (was as high as 50% in 1990). • These markets have had wide differences in • Next: Great Britain, returns and risk. Exhibit 15.1 • Germany and France switch back and forth for • International Performance often measured by fourth and fifth place. Morgan Stanley’s EAFE index (where the largest component is Japan) 1 International Equity Investing International Equity Investing • When considering to invest in a foreign market, • Emerging markets have higher risk than you need to consider both the market’s risk (sfor ) developed markets, and until recently, higher and its correlation (? US,for) with your home returns. market (or your existing investments). • Examples: all of Asia excluding Japan, Latin • Best diversification is with other markets that are America, East Europe, Africa, MidEast. (in order not well correlated with your own. of market size) • Exhibit 15.2, 15.6 give different nations’ stock • Major benefit: Cross-market correlations of the market correlation with USA. emerging markets with USA tend to be very low. • Canada highest (thus worst), Japan lowest (thus • Exhibit 15.10 best) among developed countries. International Equity Investing International Equity Investing • Correlation and the Gains From Diversification: Foreign market Betas • Calculation of Expected Return of a global • portfolio: • Beta = Correlation [sfor/ sUS] • You derive the greatest reduction in U.S. portfolio risk • rp = a rUS + ( 1 - a) rrw by investing in countries that have a combination of low volatility and low correlation with your home stock • where rp = portfolio expected return market • r = expected U.S. market return • Exhibit 15.3 demonstrates how portfolio risk is lowered US with global diversification. • rrw = expected return for the • Exhibit 15.4 shows how the World index is ”smoother” • “rest of the world” (less risky) than either the US or EAFE indexes. • a = percent invested in US assets International Equity Investing International Equity Investing • Calculation of Expected Portfolio Risk (sP ) • Methods to Diversify • 1. Invest in U. S. Multinational Corporations. 2 2 2 2 1/2 • sP = [a sUS + (1- a) srw + 2 a(1- a)sUSsrw?US,rw] • 2. Invest American Depository receipts (ADRs) or similar “American shares”. • ? = the cross-market correlation • 3. Hold internationally diversified mutual funds: (open- US,rw or closed-end) • a = proportion of the portfolio in the U.S. (use decimal) • a. Global Funds (U.S. and foreign assets) 2 • b. International Funds (foreign only) • sUS = variance of U.S. returns • s 2 = variance of International returns • c. Regional or “country funds” rw • d.WEBs (or exchange-traded funds) on the American • (note: global and world usually mean all markets) Stock Exchange. • See Exhibit 15.8 for an example of rP and sP holding different proportions of US and foreign assets. • Symbols EWT,EWM,EWA,EWG,EWS,EWJ,EWC, etc. 2 Investing in U.S. Multinationals American Depository Receipts • Having earning from overseas ‘should’ make the • ADRs essentially allow foreign securities to company less dependent on the U.S. economy. trade in U.S. stock markets. Ex. Coca Cola earns 80-90% of its earnings • Over 1000 foreign companies trade on the US, overseas. McDonalds, Caterpillar, Boeing, etc. either on the NYSE or NASDAQ. are similar. • Examples BP, SNE, TM, GLX, DMC, TMX • Problem: U.S. based MNCs still appear to be • The ADR simply "represents" the actual correlated, and not really distinct from the foreign shares (which are deposited at a trust performance of a U.S. stock portfolio. bank). The ADR may represent one share or ten • In the long-term the strategy may work, but it shares, or even a tenth of a foreign share. appears to be diversifying only in theory . • Info on ADRs can be found on www.adr.com American Depository Receipts American Depository Receipts • The benefits of the ADR (over owning the • ADRs and the underlying foreign stock are foreign shares directly) linked through the process of arbitrage: since the • (1) Easier and cheaper buying and selling: All ADR and stock are substitutes, the arbitrageur transactions are done in dollars, in the U.S. and will buy the cheapest one and sell or short-sell the during regular U.S. trading times. more expensive one. • (2) Dividends automatically converted to • ADR (in $) = (foreign stock price)(CR)(e0) dollars, probably at the ‘wholesale’ (money- • Where the stock price is in the local currency, center bank) exchange rate. • and e is the exchange rate in American terms. • (3) Financial and accounting information is 0 required to conform (at least partially) with U.S. • Note: the ADR price is directly related to the standards. currency value. (thus, there’s still currency risk) American Depository Receipts American Depository Receipts • the CR is the conversion ratio between the ADR • If Glaxo sells in London for 12 pounds, there are and the foreign stock. CR = #for shares/#adrs. two foreign shares for one ADR and the pound is CR is ‘one–to-one’ maybe half the time: usually worth $1.60. for Germany and Japan. E.g. Sony and Daimler- • What should the ADR sell for ? Chrysler shares are each represented by one ADR. • FS CR e = adr • The UK tends to have low-priced shares because 0 • (£12/share)(2sh/1adr)($1.60/£) = $38.40/adr they issue extra shares through rights offerings. • Prices may not match up because • The Swiss rarely split shares so their stocks are high priced. • 1) adr’s may be the only way for foreigners to buy the shares (the adrs will then sell at a premium) • Emerging markets usually have low-priced shares. • 2) Asynchronous trading (think time zones) 3 International Bond Investing Developed Country Bonds • Bond markets: The biggest by far is for U.S. dollars, in particular Treasury securities. These • Adding international bonds to a diversified markets have growth a great deal in recent portfolio can lower a portfolio’s risk-return ratio, and may even raise returns. decades because of large and persistent balance of payments differences: The U.S. has issued many • In the case of developed country bonds, these bonds are usually pay interest and principle in a bonds to finance past federal deficits. major hard currency (EUR, CHF, Yen, GBP, • Japan, Hong Kong, China, etc, have purchased CND, or AUD). these bonds as they have had persistent trade • Since bond prices do not vary as much as stock and current account surpluses. The need to prices, most of the risk is currency risk. invest capital surpluses is a major driver in the • Thus, good if the USD is weakening. expansion of the debt markets. Emerging Market Bonds International Bond Investing • These are the Junk Bonds of international investing. • Fidelity offers a well-run fund that invest in these • These bonds are usually issued in dollars, as lenders bonds (New Markets Fund). Also Scudder. are unwilling to assume the currency risk. • There are also closed-end funds. (TEI, etc.) • There really is still currency risk in the sense that a sharp devaluation makes it very difficult for LDC • I question the necessity (or wisdom) of adding borrowers to repay dollar liabilities. international bonds to a portfolio. • Recall USD bank deposits in Argentina (and Mexico • Transactions costs may be high and many of the in the 1980s) were forcibly converted to local famous “hard currencies” such as the Yen and currency. the Swiss franc offer very low yields. These are • Volatile, these bonds are often a good buy after crises in effect pure currency plays. You should be (which seem to occur every few years). better off in Swiss and Japanese equities. International Bond Investing Measuring Total Return: the Addition of Currency Risk. • The “King of Indexers”, the Vanguard Group does not offer an international bond fund for • In almost all cases equities are priced in the similar reasons. That being said, if you wished currency of the foreign country. to speculate that the dollar will fall, these bonds may well - if interest rates don’t rise). However, • Bonds issued by developed countries, and there are better ways of betting on currencies. corporation within those countries are mostly in • We like the U.S. bond market as a good the foreign currency.
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