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Savvy investors look to international mutual funds for a couple of important reasons.
By: Robert F. Abbott, freelance writer and author of Big Macs & Our Pensions
International mutual funds provide diversification, away from what’s called country-risk, the possibility that events in one country could drag down many stocks in that country while stocks in the rest of the world keep growing or go down less. In addition, stocks of other countries may provide returns greater than those available at home.
Before getting to the benefits, though, let’s clear up the language a bit.
“International funds or global funds? Aren’t they the same?”
In everyday use, international and global are
often used interchangeably. But in financial markets, they mean different things, and there are even another couple of terms commonly used. Here are some quick definitions:
- Emerging market funds invest primarily in companies based in less-developed countries.
- Global funds invest primarily in securities (including stocks and bonds) traded worldwide, including your home country.
- International funds must invest in securities located outside the home country, and cannot invest in home country securities.
- Regional funds invest in securities based in a specific part of the world (Asia or Europe, for example).
- World equity funds invested in securities traded worldwide, including companies based in the home country, specific regions, or emerging markets.
For now, don’t sweat the details; just know that when you go looking for international or global mutual funds, you may see them named differently, and that the differences are real. For the purposes of this article, I will simply refer to all of these funds as international.
Safety Through Diversification
To take an extreme example, consider the situation in Greece over the past few years, and how its economy took a beating while the rest of the world continued to recover from the 2008 financial crisis. An investor who owned only Greek stocks (or mutual funds) would have suffered huge losses; this is what we mean by country risk.
Not that international holdings necessarily make you bulletproof. When the American stock market crashed in 2008, foreign stock holdings didn’t help most investors since major markets in Europe and Asia also declined. Still, the consensus holds that your portfolio (all of your funds and stocks/bonds together) is safer with some international exposure.
How much is enough and how much is too much is beyond the scope of this article. The right proportion will depend on your risk/reward goals and the types of international funds you buy. For example, if your exposure involves Canadian government bonds, your risk will be very low (and your returns will be very low as well). On the other hand, funds with Chinese or Indian stocks could be risky, but also have more potential for capital gains (the price rising above the level at which you bought).
Check with a financial adviser or do some research online to get an idea of where your boundaries lie.
Bigger Returns (and Losses)
We’ve already touched briefly on the potential rewards awaiting those who successfully invest in international mutual funds. Let’s now explore that a bit further.
While its economy has slowed down lately, China has seen tremendous growth in the past few decades. While the economies of the traditionally industrialized countries consider Gross Domestic Product (GDP) growth of more than 2% as robust, the Chinese economy grew at rates two to four times faster. That meant companies based there also had organic growth opportunities two to four times greater than, let’s say, American companies.
Generally, that means the share prices of Chinese companies would be expected to go up faster than equivalent companies (well, roughly equivalent) in the United States or Europe. And, a mutual fund with lots of shares in Chinese companies would be expected to give you more capital appreciation than a mutual fund that focuses on European or American companies. Note the word generally at the beginning of this paragraph — in the 1990s I bought into a Japanese growth fund with high expectations and waited, and waited, and waited; eventually I sold it at a loss. Sometimes these investments work for you, and sometimes they don’t.
One more note on the risk to reward ratio: Unless otherwise assured, assume that the risks (and likely the rewards) of international funds will be more volatile (prices fluctuate more) than domestic funds of the same type. For example, of we compare an international large cap fund against a domestic large cap fund, we would expect the price of the international fund to go both higher and lower than the domestic fund.
Narrowing the Field
With literally thousands of potential international, global, world, and other non-domestic funds to choose from, how do you narrow the field?
Unless you have specific knowledge of a specific region or country, you’ll need to do what the rest of us do — homework. If you have a financial advisor, use his or her expertise or (in most cases) access to experts.
If you’re on your own and you’ve decided on a particular fund family (company), you can look for their recommendations or even portfolios. Needless to say, you should do as much research as possible, and the vast wealth of online resources makes that far easier than it was just a decade ago.
The Other Option
For those who like simplicity, another way to achieve international diversification is through shares of companies with lots of international exposure. Most of the Fortune 500 companies have exposure of one kind or another to the rest of the world. In some cases, they earn more from international operations than from their American operations.
Coca-Cola and WalMart, for example, are big players worldwide. One interesting case is that of Aflac, the American insurance company made famous by its iconic quacking duck commercials. As I noted in a 2014 profile of the company, Aflac “…focuses on specialty insurance lines, particularly those connected with health care. And, about three-quarters of its revenues are booked in Japan.”
So, you might look for international mutual funds holding big American companies with strong exposure in other countries. This should become reasonably clear when you read a detailed descriptions of individual funds.
Fees and Expenses
Running an international mutual fund costs a fund company more than a domestic fund. After all, it will spend more to do research, do trades, and maintain all the paperwork. And, fund companies pass those costs on.
However, some companies do this more efficiently than others. That means they can charge lower MERs, Management Expense Ratios, than other firms. The amount you pay as an MER makes absolutely no difference to the fund’s performance, so generally we will choose lower-priced funds if we’re looking at comparable funds.
Also, frontend and backend fees can seriously chew into your returns, so avoid them if possible. Frontend fees refer to sales charges levied by some mutual fund companies when you buy a fund or funds, and backend fees refer to those you pay when you close out a fund or funds. These fees normally represent sales commissions to brokers and some financial advisors, and again, make no difference to how well the fund performs. Unless you have some compelling reason to do otherwise, opt for no-load funds when shopping.
Conclusions: International Mutual Funds
Before buying international mutual funds, know why you’re buying them. In other words, be strategic. In many cases, you will want an international fund that will give you more diversification of your portfolio. Other goals can be just as valid, so long as you know what you’re buying and why you’re buying it.
Diversification: Just one more kick at this can. Diversification provides greater safety, which means smaller losses if the market turns against you. When done right, diversification can also provide you with greater returns.
For many investors, this kind of diversification involves an allocation of perhaps 5% to 10% of their portfolios; enough to make a difference but not enough to hurt seriously if the investment goes sour. Allocations vary, of course, depending on such factors as age and risk tolerance.
Fees and charges will make a material difference in your returns; look for lower MERs and choose no-load funds over frontend and backend funds whenever possible.
Finally, international mutual funds, whatever their stripe, can play an important role in creating a strong and profitable portfolio. And the research you do before buying will make your future prospects that much brighter.
Next, read about Mutual Fund Diversification
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