Methods used to Invest Internationally – 5 Common Methods

Invest Method Internationally:

For investors attempting international stock diversification,   five common approaches are available:

  • Direct Purchases of Foreign Stocks
  • Investment in MNC Stocks
  • American Depository Receipts (ADRs)
  • Exchange Traded Funds (ETFs)
  • International Mutual Funds (IMFs)

Direct Purchases of Foreign Stocks:

Foreign stocks can be purchased on foreign stock exchange. This requires the services of brokerage firms that can execute the trades desired by investors at the foreign stock exchange of concern. However, this approach is inefficient because of market imperfections such as, insufficient information, transaction costs, and tax differentials among countries.

An alternative method of investing directly in foreign stocks is to purchase stocks of foreign companies that are sold on the local stock exchange. In the United States, Royal Dutch Shell (Netherland), Sony (of Japan), and many other foreign stocks are sold on U.S. stock exchanges. Because the number of foreign stocks listed on any local stock exchange is typically quite limited, this method by itself may not be adequate to achieve the full benefits of international diversification.

Brokerage firms have expanded the list of non-U.S. stocks that are available to U.S. investors. For example, Fidelity now executes stock transactions in many different countries for its U.S. investors. The transaction cost of investing directly in foreign stocks is higher than purchasing stocks on U.S. stock exchanges. One reason for the higher cost is that the foreign shares purchased by U.S. investors typically remain in the foreign country, and there is a cost of storing the stocks and processing records of ownership.

Investment in MNC Stocks:

The operations of an MNC represent international diversification. Like an investor with a well managed stock portfolio, an MNC can reduce risk by diversifying sales not only among industries but also among countries. In this sense, the MNC as a single firm can achieve stability similar to that of an internationally diversified stock portfolio.

If MNC stocks behave like an international stock portfolio, then they should be sensitive to the stock markets of the various countries in which they operate. The sensitivity of returns of MNCs based in a particular country to specific international stock markets can be measured as:

RMNC  = a0 + a1RL + b1RI,1 + b2RI,2 + …… + bnRI,n + u

Where  RMNC  is the average return on a portfolio of MNCs from the same country, a0 is the intercept, RL is the return on the local stock market, RI,1 through  RI,n are returns on foreign stock indices I1 through In and u is an error term.

American Depository Receipts:

Another approach is to purchase American depository receipts (ADRs), which are certificate representing ownership of foreign stocks. More than 1000 ADRs are available in the United States, primarily traded on the over the counter (OTC) stock market. An investment in ADRs may be an adequate substitute for direct investment in foreign stocks.

Exchange Traded Funds (ETFs):

Although investors have closely monitored international stock indexes for years, they are typically unable to invest directly in these indexes. The index was simply a measure of performance for a set of stocks but was not traded. Exchange traded funds (ETFs) represent indexes that reflect composites of stocks for particular countries; they were created to allow investors to invest directly in a stocks index representing any one of several countries. ETFs are sometimes referred to as world equity benchmark shares (WEBS) or as iShares.

International Mutual Funds:

A final approach to consider is purchasing shares of International Mutual Funds (IMFs), which are portfolios of stocks from various countries. Several investment firms, such as Fidelity, Vanguard, and Merrill Lynch, have constructed IMFs for their customers. Like domestic mutual funds, IMFs are popular due to (i) the low minimum investment necessary to participate in the funds, (ii) the presumed expertise of the portfolio managers, and (iii) the high degree of diversification achieved by the portfolios’ inclusion of several stocks.

Many investors believe an IMF can better reduce risk than a purely domestic mutual fund because the IMF includes foreign securities. An IMF represents a prepackage portfolio, so investors who use it do not need to construct their own portfolios. Although some investors prefer to construct their own portfolios, the existence of numerous IMFs on the market today allows investors to select the one that most closely resembles the type of portfolio they would have constructed on their own. Moreover, some investors feel more comfortable with a professional manager managing the international portfolio.

I have discussed above the five methods used to invest internationally. These are main methods of investment international process.