Many more stocks trade outside of the United States than within. Depending on which stock markets one includes or excludes and the criteria one uses to select stocks, the universe of available investments may be three or four times as large.
This guide is for people who are interested in the idea of investing in foreign stocks but are uncertain of how to proceed.
Table of Contents
Choosing a Broker
What Types of Accounts
How to Find Foreign Stock Ideas
Researching Foreign Stocks
Trading Foreign Stocks
Foreign Currency Transactions and Exposures
Currency Exposure Management
Taxes and Paperwork
The best stock foreign stock markets are the ones that are best positioned to help you meet your investment and financial objectives. While there are many variables to consider, we would begin the process of investing in foreign stocks by focusing on three variables: transaction costs, counterparty risk and regulatory risk.
Does foreign stock investing make sense for both short-term and long-term investors? The cost of trading varies tremendously from market to market. In some cases, the trading of foreign shares does not cost much more than the cost of trading shares in the United States.
If one is a momentum investor who expects to trade frequently, one will want to focus on the stock markets that have the lowest trading costs. If one’s investment strategy focuses on undervalued stocks and one does not expect to trade frequently, higher trading costs may not represent a significant barrier to investing in a specific stock market.
The cost of trading varies tremendously from market to market. In some cases, the trading of foreign shares does not cost much more than the cost of trading shares in the United States. One typically finds low costs if the stock exchange is all-electronic and the settlement of trades is by book- entry only.
In other cases, the market structure may involve floor brokers and the exchange of physical stock certificates. Trading such markets may cost much more than what one expects in the United States.
One must also consider the cost of converting currencies. Currency conversion costs range from negligible to a multiple of the commissions one pays to trade a stock.
Counterparty risk pertains to getting paid. For example, one executes a trade to sell a stock at $50.00 per share. One sends the shares to the buyer’s broker. Do they send the cash immediately, or days later according to local business regulations? Alternatively, one agrees to buy stock for $50.00 per share. One sends the cash to the seller’s broker. Do they send back the shares immediately, or later?
What happens if the counterparty goes bankrupt after they have received the shares one sold, but before they have sent back the cash?
For the typical U.S.-based investor who uses a U.S.-registered broker to buy or sell U.S.-registered stocks, the U.S. regulatory and market structure reduces counterparty risk to the bare minimum.
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.
Wealthier countries tend to have structures in place to reduce this type of counterparty risk.
Although far from perfect, the United States maintains a fairly rigorous regulatory structure for stocks.
The same cannot be said for other countries. Foreign stock regulators may not have a well-developed regulatory structure to protect the interests of investors.
Where ample regulations exist, the funding to enforce the regulations may not. If the foreign government does not provide adequate funding, there may not be a sufficient number of regulatory personnel to discourage unethical or criminal behavior.
One should also consider account insurance. Brokerage accounts in the United States are insured against certain types of theft and similar losses by the broker. A foreign broker may not protect the investor in that way.
In deciding what foreign stock markets in which to invest, one can design a due diligence process to bring some clarity to the issues of transaction costs, counterparty risk and regulatory risk.
Alternatively, one can limit oneself to trading only those markets that are available through a U.S.-registered broker. Doing business with a U.S.-registered broker does not eliminate the need to do research on foreign markets. But we believe doing so will narrow some of the risks because most reputable U.S.-registered brokers will have due diligence processes in place to protect their customers.
Choosing a Broker
One’s choice of a stock broker is an important consideration. One should think about the range of offerings and the likely transaction costs.
RANGE OF OFFERINGS
No single broker offers access to the top 30 or 40 stock exchanges. In the United States, the broadest offering covers stocks traded in 25 different foreign countries. The least costly broker offers access to stocks traded in 15 foreign countries.
The U.S.-registered brokers offer access to almost all of the economically advanced countries. They exclude certain important developed ones, notably Taiwan, South Korea and Israel. They also exclude some less developed countries, such as Philippines, Thailand, Malaysia, Indonesia, Russia, Egypt and Hungary. Some of these foreign markets may offer outstanding value or momentum stocks.
If one wants access to countries that are not available through a U.S.-registered broker, one must open an account with a foreign broker. Foreign brokers operate under a different regulatory scheme. Investor protections may differ.
The cost of trading foreign stocks is higher than what one generally encounters trading U.S.-registered stocks in the United States.
The higher cost may simply reflect a higher cost of doing business that the broker passes on to the customer. If the foreign stock market employs large numbers of people rather than relying on digital trading technology, trading costs will be high. Similarly, if the local business practices require the recording of share ownership changes by exchanging physical stock certificates rather than electronic entries into the shareholder register, trading costs will be high.
Currency trading costs must be considered separately. Foreign stock exchanges settle trades in their own currency. For the U.S. investor to buy the foreign stock, one must come up with foreign currency either by converting U.S. Dollars into the foreign currency or by borrowing the foreign currency. The cost of converting or borrowing ranges from de minimus to exorbitant, depending on the broker.
Certain types of investment strategies may become untenable in the face of high transaction costs. In that case, a strategy focusing on undervalued stocks may be best.
Finally, due to burdensome U.S. financial regulations, many foreign brokers refuse to allow Americans to open financial accounts.
What Types of Accounts?
What type of account should one use to fund investments in foreign stocks?
Should one use personal funds or the funds in one’s retirement account? If one has a trust account, should one use it to make the investments? What about another structure – perhaps a corporation, a partnership, a limited liability company or something similar?
As one can imagine, the answer depends on the circumstances and what kinds of costs and uncertainty one is willing to accommodate. Most of the challenges relate to taxes and to tax paperwork in particular.
Based on our research, we believe using a personal account to invest in foreign stocks minimizes the tax and paperwork hassles. If one chooses the countries carefully, the tax compliance obligations could be as little as filing an extra form or two with the Internal Revenue Service.
Trust accounts can be tricky. The basic problem is one of legal status or lack thereof. Many countries are unfamiliar with trusts and have made no accommodation for them in their tax laws. Lack of status can create unpredictable tax results. Specifically, in such countries the foreign tax authorities may assign the trust income to someone other than the trust – perhaps a beneficiary, but maybe not. In addition, the tax paperwork requirements for a foreign trust may be more onerous than for a natural person.
Individual retirement accounts face many of the problems of trusts because individual retirement accounts are trusts, too. See Section 408(a) of the Internal Revenue Code: “… 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]. In addition, foreign governments may or may not recognize the tax deferral features of a U.S. individual retirement account.
Corporations, partnerships, LLCs and similar entities introduce another layer of complexity. You may face additional filing requirements based on the specifics of the structure, perhaps so the foreign governments can track the income of the owners of the entity.
How to Find Foreign Stock Ideas
How does one find a list of stocks that might be worthy of further research?
If one has large amounts of money to spend, one can subscribe to an institutional-quality research database. The cost of such databases likely exceeds the resources of most small institutions or individual investors.
A cost-free alternative is the global stock screener offered by the Financial Times. FT offers some predefined screens plus the ability for one to create a custom screen. While the FT screener offers relatively few variables on which to screen, they offer enough to reduce the research list down to dozens of stocks from tens of thousands.
In some countries – particularly the Anglophone ones in which investing in stocks is a popular past time – active discussion boards and chat rooms can provide investment ideas.
Stock exchanges sometimes provide financial information about the shares they trade. They may offer a simple screener to identify the more promising potential investments.
Newsletters focusing on foreign stocks are rare. We searched hard for them and came up with nothing that met our requirements. To plug this hole, we stepped up and created our own. We offer two newsletters, designed to meet different investment styles:
- The Global Deep Value Letter which focuses on undervalued stocks with good quality. This letter is designed for the classic “value” investor.
- The Global Value-Momentum-Quality Letter. As suggested by the title, this letter looks for stocks that are attractive on three metrics – value, momentum, and quality. This letter is designed for “momentum” investors who want stocks that have performed well. Because investors can get carried away on the upside, this letter includes value as a stock selection criteria. The stocks in this portfolio are not as undervalued as the stocks in the Global Deep Value Letter, but they nonetheless seem undervalued to us.
Researching Foreign Stocks
Let’s imagine that one has a list of foreign undervalued stocks that appear to have some potential. Some people will throw caution to the wind and just buy them. But most people will want to do additional research.
In the United States, obtaining financial information about U.S.-registered stocks is not difficult. One can start with a company’s website. Most companies having securities traded by the public include an “investor relations” page on their websites. The page usually includes information about the stock and copies of important corporate filings.
If a company’s investor relations outreach is insufficient or non-existent, one can turn to the Federal government. The EDGAR system of the United States Securities and Exchange Commission warehouses an enormous number of corporate filings. If one knows the name or the trading symbol, one can obtain an indexed listing of a company’s filings.
One can also go to websites like Yahoo! or Morningstar to find financial information about U.S.-registered stocks.
If one is investing in foreign stocks, the research process is similar. Many foreign companies maintain an investor relations page on their website. If the company website does not provide adequate information, one may be able to find official corporate filings online, possibly with the Ministry of Finance (or equivalent), the securities regulator or the stock exchange that makes a market in the stock.
One should expect that foreign websites and financial filings likely will be in a foreign language. If one cannot read the foreign language, one can obtain a translation for free by using Google Translate. Simply cut and paste the text into Google Translate. Even better, Chrome Browser users can click on the translate button in the right corner of the browser’s address bar.
When one clicks on the icon, this will appear:
The translation may be of mediocre quality, but one can get the gist of what the page says.
If does not want to bother with document translation, one can consider websites that aggregate information about global stock opportunities. For example, the Financial Times website can be searched for detailed financial and other information on specific stocks.
Trading Foreign Stocks
While not difficult to master, the mechanics of trading foreign stocks are a little different than trading U.S. stocks. People investing in foreign stocks should plan accordingly.
The most obvious difference is that foreign stocks are priced in a foreign currency. For countries with currencies that have little value per unit, one should expect to see stocks trading for very large amounts of currency. In the U.S., it would be unusual to see a stock trading for more than $2,000 per share. In contrast, many Japanese stocks trade for more than 2,000 Yen per share. With an exchange rate of more than 100 Yen per U.S. dollar, a Yen price of 2,000 is the equivalent of less than US$20.00.
DIFFERENT TRADING HOURS
The U.S. stock markets are open from 9:30 AM to 4:00 PM – a full six and a half hours. Other markets may be open for shorter periods of time or may have more than one session during the day. For example, the Tokyo Stock Exchange has two 150-minute sessions, one in the morning and one in the afternoon with a one-hour break between the two.
TIME ZONE DIFFERENCES
If one lives on the East Coast of the United States, trading in Japan is about one-half of a day ahead. Thus, to trade Tokyo on Monday morning, one trades in New York on Sunday evening. To trade Tokyo on Friday morning, one trades in New York on Thursday evening. The Tokyo market is closed for the weekend during Friday New York regular business hours.
Europe’s regular trading hours are the equivalent of early morning for East Coast United States investors.
Countries may have different types of symbols for stocks. In the U.S. we use the letters of the alphabet. Many countries have adopted the same practice. In Japan, the symbols are numbers – e.g., “6160” or “6161.” Other countries use a combination of letters and numbers.
MINIMUM SHARE LOTS
In the U.S. and in many other countries, the minimum trade size is one share. Other countries may require minimum trades of one hundred or even one thousand shares.
Foreign Currency Transactions and Exposures
When one starts investing in foreign stocks, one must learn to work with foreign currencies.
Foreign currency is an issue not just in the buying and in the selling of foreign stocks. If the stock does not rise or fall but the currency moves, one’s net worth (expressed in U.S. Dollars) will move solely because of the movement of the currency.
If one opens an account with a brokerage firm like Interactive Brokers, one has three options for managing currency exposure:
- Exchange currencies;
- Borrow currencies;
- Hedge currencies using futures.
One can exchange currencies as part of one’s investment program. This means if one needs Japanese Yen to settle a trade, one sells U.S. Dollars to buy Japanese Yen.
The sale of a Japanese stock will settle in Japanese Yen. If one needs U.S. Dollars, one sells the Japanese Yen to buy the needed U.S. Dollars.
Interactive Brokers charges a commission every time it exchanges currencies. The commission is small.
Companies like Interactive Brokers also provide foreign currency margin loans. Instead of having to convert U.S. Dollars into Japanese Yen in order to settle the purchase of a Japanese stock, one simply borrows as many Yen as one needs to settle the trade. When one sells the stock, the proceeds from the sale (in Japanese Yen) are used to pay down the Japanese Yen margin loan.
Margin loans are a natural currency hedge. One owns a foreign currency asset (the foreign stock) and incurs an offsetting foreign currency liability (the margin loan).
The brokerage firm charges interest on outstanding loan balances. One must maintain sufficient collateral to avoid margin calls.
HEDGE CURRENCIES USING FUTURES
One can use futures to hedge currency exposures. When one enters into a futures contract, one agrees to receive or to deliver foreign currency at a specific time in the future.
If one has a long futures position, one agrees to receive the foreign currency. Economically, this is equivalent to owning the foreign currency. If one has a short futures position, one agrees to deliver foreign currency. Economically, this is the equivalent of having borrowed the currency.
Generally, one may hedge the currency exposure of a foreign stock position by going short a foreign currency futures position.
Trading futures incurs commission costs. One must maintain adequate collateral to avoid margin calls on the future position.
Currency Exposure Management
Ownership of a foreign stock does not require one to assume the risk of the foreign currency. One can easily reduce or eliminate altogether the risk of owning the currency while preserving exposure to the performance of the foreign stock.
If the prospects for a currency look good, then one might consider having an unhedged position. This means taking on the full exposure to the currency. In contrast, if the prospects for a currency do not look good, one might consider hedging the risk.
How does one decide whether a currency has good or not good prospects? While one 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 a trend in place may have a tendency to continue. Thus, if the trend of a currency is upwards (meaning it is becoming more valuable over time), we assume that the odds may be a little better that the currency will become more valuable in the near term. Contrariwise, if the trend of a currency is downwards (meaning has been losing value over time), we tend to think that it may continue to lose value.
In our view, currencies with higher yielding short-term investment opportunities may be more attractive than currencies with lower yielding short-term investment opportunities. By short-term investment opportunities, we mean the highest quality government short-term bills, notes or bonds available to investors.
In comparing yields, one must make appropriate adjustments for differences in credit risk. Governments with speculative credit grades should yield more than investment grade governments.
One should also make adjustments for inflation rates. The currencies of high inflation economies may lose value faster than the currencies of low inflation economies. Consequently, one should consider looking at the real interest rate by deducting from the interest rate the rate of inflation. Currencies with higher real interest rates may perform better than currencies with lower real interest rates.
PURCHASING POWER PARITY
Another approach is to consider what equivalent amounts of currency can buy in each country. If US$ 100 buys a nice gift, does the same amount of money converted into Euros buy two nice gifts? If yes, then owning Euros may be a better idea than owning U.S. Dollars.
Taxes and Paperwork
Investing in foreign stocks likely will create additional tax paperwork and – possibly – some new tax liabilities for the investor. The nature of one’s new compliance responsibilities depends in part on the countries in which one chooses to invest. For a number of countries, the foreign individual investor faces a light incremental tax compliance burden. For a few countries, the hassles are significant.
THE NATURE OF TAX COMPLIANCE
Tax compliance includes two distinct concepts:
- Paying the correct amount of tax, and
- Filing the correct income declaration forms.
In many countries, one must do both correctly. One can be fined for not paying the tax. Even if one has paid the correct amount of tax, one may still have to file forms declaring the income that gave rise to the tax. A failure to declare income on the correct form may itself give rise to a fine. If unpaid the fine can compound over time.
FOREIGN TAX COMPLIANCE
In most cases, calculating and paying the foreign tax is the easy part. Frequently, the foreign governments tax only the income from one’s foreign stocks. The tax likely will be withheld fully from the dividends. The dividend payor remits the tax directly to the foreign government. In many cases (but not all), capital gains are entirely exempt from foreign tax.
Filing the correct paperwork is less clear. A number of 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. The dividend payor already has provided the information to the government when the payor remitted the withholding. For the taxpayer to submit an additional return would impose an unnecessary cost on the foreign government’s tax administration.
However, not all governments feel this way. One must take care to understand what paperwork the various governments require. A review of the details vastly exceeds the scope of this post. My book covers this information for a large number of countries.
U.S. TAX COMPLIANCE
While foreign governments may impose a light or no tax on the income and capital gains of U.S. investors in foreign stocks, the U.S. taxing authorities will fully tax such earnings.
The tax code provides for tax credits to offset taxes paid to foreign governments. Thus, it is highly likely that one will not have to pay duplicative taxes to the U.S. and to foreign governments. One may have to file an additional form in order to claim the foreign tax credit.
In fulfilling one’s U.S. tax compliance responsibilities, one will also have to pay attention to FATCA and FBAR. These forms are less about measuring and taxing income than making sure that the taxpayer is not hiding foreign income from the U.S. tax authorities. One does not want to make mistakes with these forms … the fines for non-compliance can be astonishing. FATCA and FBAR mostly (but not entirely) apply to people who have foreign financial accounts. Depending on the types of securities in which one invests, carrying on one’s foreign investment activities through a U.S. brokerage account may relieve one of having to file FATCA and FBAR forms.