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How to add international exposure to your portfolio

Last week we considered the pros and cons of adding international stocks to your portfolio, this week we look at how.

Last week we considered the pros and cons of adding international stocks to your portfolio, this week we look at how.

How can I invest in international shares?

There are a number of ways to invest in international shares:

Directly

You could pick a handful of stocks and try to invest directly.  This is a little tricky, because foreign stocks are listed on foreign stock exchanges, which are not easily accessible.  Some brokers in Australia do allow you to purchase stocks listed on certain foreign exchanges. 

However, before you do this it is important to consider the impact of foreign exchange on your investment.  If your international share portfolio rises by 10%, but the Australian dollar appreciates by 10%, then your net return will be 0.  It is hard to manage this foreign exchange rate risk when you purchase shares directly.

Exchange Traded Funds

It is possible to invest in international equities via an exchange traded fund (“ETF”).  This means that you can purchase the international equity ETF on the Australian stock exchange (the same way you would a share) and get access to a number of international stock markets.  The upside is that you get access to a diversified international portfolio, through a purchase in Australia, and you can choose a hedged portfolio (more on that below) to minimise your foreign exchange rate risk.  The downside is that you will pay a fee for this management, usually around 0.3% to 0.5%p.a.

Managed Fund

Another option is to invest via a fund manager, this allows you to invest in a professionally managed portfolio of international stocks.  This is a simpler option that investing directly in a number of different stock exchanges, and you get access to professional investment expertise, including expertise in managing foreign exchange rate risk. 

The downside is that this will cost you between 1-2% p.a. According to the SPIVA report just over 10% of international managed funds in Australia outperformed the index over the last 10 years.

The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs before acting on the advice.

The pros and cons of going international

Last week we covered Australian equities.  This week we cover International shares and the pros and cons of adding them to your portfolio.

Why invest in international shares?

One of the main reasons to invest in international shares is diversification.

Sector Diversification 

In Australia, approximately 60% (by market capitalisation) of the top 100 companies operate in a very narrow set of industries, namely financials, mining & materials, and energy.  If you invest only in the Australian market, your portfolio may lack sector diversification. 

By investing internationally, you get access to other sectors. For example, the top sector in the US is Information Technology, which accounts for over 20% of the 500 largest companies in the US.  In Australia, information technology accounts for only 0.85% of the 100 largest companies.

Geographic Diversification

If you invest only in the Australian market, the performance of your portfolio will be tied to the performance of the Australian economy.  This can be problematic because your financial well being (i.e. your ability to find work, buy a house, meet interest repayments) is also tied to the performance of the Australian economy. 

Investing internationally helps to diversify your investment risk, by providing access to markets outside of Australia.

What are the risks of investing internationally?

Lack of familiarity

If you’re investing in Australia, there is a good chance that you have used the services of the company you are investing in, or at least be familiar with them.  This is a good starting point for the due diligence an investor should complete prior to investing.

If you are investing offshore, the due diligence is a little harder as you don’t have “local knowledge”, like what’s the difference between Walmart and Home Depot?  or who shops at Whole Foods? You become entirely reliant on research reports to form a view on a company, instead of first hand knowledge.

Foreign Exchange

Another risk with investing internationally is foreign exchange. 

When you invest internationally, you are selling Australian dollars and buying the currency of the investment.  This means that the value of your investment will fall in Australian dollar terms when the Australian dollar rises, so you are exposed to the risk of the Australian dollar appreciating (going up).

If you invest via a managed fund, or an ETF, you are likely to have the option to hedge your foreign exchange rate risk.  If you go with a hedged option, the fund manager will pay a fee to lock in a set foreign exchange rate.   This means that you are protected if the Australian dollar appreciates, but you will miss any upside if the dollar depreciates.

Hedging does not eliminate foreign exchange rate risk, instead you are paying a fee (via the cost of the hedge) to manage it.

The decision of whether or not to hedge is a very personal one and will depend on your ability and willingness to take on risk.  Foreign exchange can be very volatile, if you do not like volatility you should consider hedging any foreign exchange rate risk in your portfolio.  The chart below shows the Australian Dollar / US Dollar exchange rate over the last 10 years, as you can see the rate has been very volatile.

SMLXL

Source: Yahoo Finance

The USD is one of the most frequently traded currencies.  If you are investing offshore, try to stick to the liquid currencies (USD, Euros, Sterling) and avoid the smaller, less frequently traded currencies.

Perceived Diversification

Investing internationally should result in a more diversified portfolio, if you make the right investments.  If you invest in a handful of international stocks in the US technology industry, then you have added only a small additional layer of diversification to your portfolio.  To get the largest diversification benefit from international stocks, try to avoid concentrating your stocks in a particular industry or country.

Next week we are going to look at how to add international exposure to your portfolio.

The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs before acting on the advice.

 

Shares, Stocks or Equities?

This week we are going to talk about shares, probably the most well known kind of investment.

This week we are going to talk about shares, probably the most well known kind of investment. 

Shares are also known as equity, or stocks.  We will use all three terms interchangeably.

What are Shares?

When you buy shares in a company, you are buying part of the company, meaning that you become a part owner of the company. As a part owner you have the right to:

  • Share in the profits of the company:  Any profits that are distributed to shareholders will be paid to you as a dividend.  Dividends are usually paid semi-annually.

  • Vote:  When key decisions are made in the company, as a shareholder, you will have the right to vote.  For example, you may get to vote at the Annual General Meeting (AGM) about which directors to elect, or how much company executives should be paid.

Shares are very different from bonds.  When you invest in bonds, you are lending money to a company.  When you purchase shares, you are becoming a part owner of a company.

Why Invest in Shares?

Shares are a key part of any investment portfolio. The top reasons why you would invest in shares are:

Capital Growth: Australian shares generated a higher investment return than either cash or bonds, with an average per annum return over the last 20 years of 8.70%.  Investing in shares helps grow your investment (also known as capital) over time and achieve a portfolio growth rate that is ahead of inflation. 

Dividends and Franking Credits: Some people invest in shares for the income provided by dividends.  A further benefit, when you invest in Australian shares, is the franking credits that some shares provide. 

A Franking Credit is a credit you receive for the tax that a company has already paid. A company will usually pay tax on its profits at a rate of 30%, if the dividend you receive is franked, you will receive a tax credit for the amount of tax that the company has already paid on that dividend.  This will be particularly beneficial if your marginal tax rate is below 30%.  For example, if you hold the shares in your superannuation account:

  • Prior to retirement (i.e. during the accumulation phase of your super):  Any income you receive is taxed at 15%.  This means that if you invest in shares that pay a fully-franked dividend, you’ll receive a tax credit of 30% and only pay tax of 15%, leaving you 15% better off.

  • In Retirement (during the pension phase): You don’t pay any tax on the income generated from your superannuation account.  If you invest in shares that pay a fully-franked dividend, you’ll get the full benefit of the 30% tax credit.

How to Invest in Shares

When investing in shares you have a number of options:

  • Invest Directly:  You could pick a portfolio of stocks to invest in.  If you go down this route you’ll need to pick at least 20 stocks to ensure that you have some diversification in your portfolio, with the stocks spread between different industries and geographies.  You’ll also need to keep on top of the performance of these stocks to make sure that their returns are in line with your expectations.

  • Invest via a Passive Fund:  There are a number of exchange-traded funds (ETFs) available which give you access to different segments of the market.  For example, you could purchase an ETF that gives you access to the ASX200, which is the largest 200 companies on the Australian Stock Exchange.  There are also ETFs available by sector (e.g. healthcare) or by size of company (e.g. small cap stocks), or by geography (e.g. international ETFs).  To invest via an ETF you are likely to pay a fee of between 0.10 – 0.50%p.a.

  • Invest via a Managed Fund:  Alternatively, you could pay a fund manager 1 – 2% with the belief that they will pick well-performing stocks and outperform the passive funds or index.  According to the SPIVA scorecard, only 26% of fund managers outperformed the ASX 200 over the last 5 years.

Interestingly, the majority (52%) of managers that focused on small and mid-cap stocks (which we’ll cover in more detail next week) outperformed the market over a 5 year period.This suggests that it may be worthwhile using a passive fund to invest in the ASX200, and a fund manager to access small and mid-cap stocks.

Too many shares?

Over the last 20 years, shares have generated an average return of 8.70% per year, so why not invest 100% in shares?  The reason is risk.  A higher return is always accompanied by higher risk. 

The chart below shows the performance of the stock market over the last 10 years, as you can see the market still hasn’t returned to the highs of 2008. 

 

 

In the period from November 2007 to end of February 2009, the market dropped by over 50%.  That means that if you invested $10,000 in the whole of the market on 31 October 2007, by 1 March 2009 you would be left with $4,951 left.  As at 31 December 2016 your initial $10,000 investment would be worth $8,387.  Keep this in mind each time you are considering investing in shares.  They are an important part of an investment portfolio, but shouldn’t form 100% of it.

The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs and before acting on the advice.

Shares Q&A

There are lots of different kinds of shares, below we outline some of the common share terminology for the various categories.

What kinds of shares can I buy?

There are lots of different kinds of shares, below we outline some of the common share terminology for the various categories.

Large, Mid and Small Capital Stocks: You may have heard these terms before.  Large, Mid and Small refers to the market value of the company (also known as share capital).  In Australia:

  • Large Cap Stock: The top 50 largest companies in Australia

  • Mid Cap Stock:  The 51st to 100th largest companies in Australia

  • Small Cap Stock: The 101st to 300th largest companies in Australia

The definitions above are based on the S&P/ASX indices series.  Some fund managers may use a different definition based on a set market capital, rather than a simple ranking.  If you are investing in a Small Cap fund it is best to check what definition is being used.

Generally large cap stocks are the most liquid (which means that are easy to sell and usually have a low differential between the buy and sell price).  Small cap stocks can be less liquid and may be riskier, as they are usually less established companies, when compared to those in the Large Cap indices.

Due to the higher risk in small cap stocks, you should expect a higher return when investing in them.

Value Stocks:  A value stock is one that appears to be undervalued based on the fundamentals of the company.  Some stock analysts will look at the company fundamentals, determine the fair value, and then purchase a stock if it is below this fair value.  This is value investing.

Growth Stocks:  A growth stock is one whose earnings and revenue are expected to increase at an above market rate.  Growth stocks tend to be newer companies who are in the early growth phase.  Typically such stocks do not pay dividends, as they are reinvesting the money in further growth.  You would invest in a growth stock if increasing the value of your investment is your key concern, rather than dividends or capital preservation.

Private Equity:  So far, all the shares that we have been talking about are listed on the stock exchange, and are therefore available to the public.  However it is also possible to buy shares in companies that are not listed on the stock exchange, these shares are called Private Equity as they are not available to the public.  Purchasing private equity is a very specialised field, and it is very risky.  In later weeks we are going to cover private equity in more detail.

What are some of the key risks of investing in shares?

There are two broad categories for risk for investing in shares:

Specific Risks: Specific risk is the risk that belongs to each stock.  For example, if you have invested in Company A, a technology stock listed on the Australian stock market then you have:

* Company Specific RiskThis covers risks related specifically to Company A.  For example a movement in their share price due to a recent release of their sales data. 

* Sector Specific Risk:  Company A is a technology company, if news is announced that negatively impacts the technology sector, as part of that sector, Company A’s stock price is likely to fall.  This is sector specific risk.

* Geographic Specific RiskCompany A is an Australian company.  If news is announced that negatively impacts Australian stocks (e.g. weak employment data), Company A’s stock price is likely to  fall. This is geographic specific risk.

Market Risks:  Market risk is the risk that comes with being part of the stock market.  If there is negative news, then the whole market is likely to react negatively and stock prices will fall.  It doesn’t matter if you are invested in Company A, or Company B, all stock prices are likely to move in the same direction.

The above highlights some of the risks of investing in stocks.  It is important to remember that there is no bottom to where a stock can fall.  If a company runs into financial trouble, debtors (including bond holders) get paid first, and shareholders get paid last.  This means that in an extreme case, your shares could be worth $0.  Prior to making an investment, it is important to consider all the risks of that particular stock, and to minimise the risks as much as possible through diversification.

Next week we are going to cover some of the benefits and risks of investing in international stocks.

The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs and before acting on the advice.

Bonds Q&A

Last week we introduced the basics of bonds, this week we’ll explain some of the features and risks in more detail.

Last week we introduced the basics of bonds, this week we’ll explain some of the features and risks in more detail.

What are the key risks of investing in bonds?

Bonds are less risky than shares, but they do still contain risk.  Below we outline some of the key ones:

Interest Rates

The price of bonds can move around depending on the level of interest rates.  For example, say that you bought the Victorian Government Green bond in 2016 which pays an interest rate of 1.75% p.a.  The cash rate at the time the bonds were issued was 1.75%, meaning you were getting paid the cash rate at the time of purchase.

Fast forward to 2019 and the cash rate is 3.50%, now you own a bond that is paying you 1.75% less than the cash rate.  Investors would rather buy a bond that is paying them the 3.5% current cash rate than one paying them 1.75%.  Because of this, the price of your 1.75% bond has gone down.  At the end of the 5 years, you will still get your $1,000 back, but in the intervening years the price of your bond will move around and you will have missed out on the additional 1.75% return that other investors were able to earn during that period.

Inflation Risk

Because bonds are generally lower risk, they also offer lower returns.  This introduces the possibility that your return may not keep up with inflation.  For example, the interest payment on the Victorian Government Bond of 1.75% is below the average inflation rate of 2.50%, which means that at the end of the 5 year term the purchasing power of your investment will have fallen, introducing the risk that during the term of your investment you may have lost money in real (i.e. inflation-adjusted) terms.

Credit Risk

In buying a bond, you are essentially lending money, leaving you exposed to the credit risk of the borrower.  A bond is a legally binding obligation to repay the debt, however a company (or Government) in bankruptcy may not have the money to repay.  As such, you should be happy with the risk of the company you are buying a bond from.

One of the key ways that people measure credit risk is via a credit rating, you can read more about them here.  The ratings go from AAA (lowest risk of default) to C (highest risk of default).  The higher the risk of default, the higher the interest rate that the bond should pay.  To minimise risk, it is generally best not to invest below a BBB- rating.

The Victorian Government is rated AAA, meaning that there is a low risk of default, which is why the interest rate is so low at 1.75%.  It is worth noting that credit ratings can change, which may impact the price of your bond. If you invest in a AAA rated bond, which is subsequently downgraded (e.g. to AA), then the price of the bond is likely to fall.

Market Risk

Bonds are part of the financial markets and are subject to falls in prices when the bond market declines.  For example, when interest rates begin increasing, the bond market as a whole usually falls due to the inverse relationship between bonds and interest rates.

Bonds are also impacted by the share market.  A study found that in periods of market volatility, the correlation between the bond and share market can get up to 0.50.  This means that if the share market drops by 1%, the bond market could drop by 0.50%.    

What types of bonds are there?

There are a wide variety of different types of bonds that you can invest in, below we have listed some of the most common:

Fixed Rate Bonds: The Victorian Government Green Bond is an example of a fixed rate bond, because the interest rate it pays (1.75%) is fixed at the date of issue and will not move.  Fixed rate bonds expose you to the risk that interest rates will rise.

Floating Rate Bonds:  Floating rate bonds are bonds where the interest rate moves, usually in line with the cash rate.  For example, the Victorian Government could have issued their green bond as paying a floating rate of the cash rate.  This means that the interest rate will increase any time the cash rate increases, and vice versa.  Floating rate notes are a good investment if you think that interest rates will be increasing soon.

Inflation Linked:  It is also possible to purchase inflation linked bonds.  These bonds pay an interest rate that is based on inflation, for example they may pay the Consumer Price Index+0.25%.  The Consumer Price Index is the most common way that inflation is measured.  Inflation-linked bonds are helpful for people on a fixed income, for example in retirement, who need to ensure that their interest payments are at least keeping pace with inflation.

Investment Grade:  Investment grade bonds are those with a credit rating of BBB- or above.  Investment grade bonds are lower risk than non-investment grade bonds.

Junk Bonds:  Non-investment grade bonds (i.e. bonds rated  less than BBB-) are also known as junk bonds.  They are higher risk than investment grade bonds.  If you decide to purchase junk bonds, make sure that you are being compensated for the higher risk by being paid a higher return, and that you are happy with the credit quality of the bond issuer.

That’s it for this week, next week we are going to move on from bonds and discuss the role of shares in your portfolio.

The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs before acting on the advice.

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