Last week we covered Australian equities. This week we cover International shares, a worthwhile addition to a portfolio if you are looking to improve geographic diversity and access a wider range of industries.
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.
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.
Too many international shares?
International shares are an important part of a portfolio, particularly for those who are able to take on a higher level of risk, however they should not form 100% of your portfolio. This is because international shares have all the same risks as Australian shares, plus the additional risk of foreign exchange fluctuations.
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.
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.
A further point to consider with international shares is diversification. 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 cover another popular asset class in Australia, Property.
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.