India, being one of the world’s emerging economies, represents only 3% of the international equity market. A portfolio with international investments gives the investor exposure to both developed and emerging markets. It also provides wider room for diversification.

 

What Is International Portfolio Management?

 

International portfolio includes stocks, bonds, cash, or other portfolio assets in a foreign country purchased by a non-resident through a cross-border transaction. For instance, if an investor based in India bought shares in a Japan based company, it would be considered as a foreign portfolio investment. It is different from Foreign Direct Investment or FDI – a financing endeavour of a non-resident to an enterprise in a foreign country solely to obtain an ownership stake or some degree of business management control.

 

Why Foreign Portfolio Investment Important?

 

A well-designed foreign portfolio investment is very significant in today’s highly volatile domestic and international markets. Every investment comes with a risk – both depreciation and volatility risks. An astute investor should take considerable effort to add additional wealth creation sources in his portfolio while diversifying the investment risk.  

 

Foreign portfolio investment provides an excellent arena for both wealth creation and diversification. The global financial markets go through numerous yielding, stagnant and losing investment time periods spread across wide geographical areas and economic systems. It provides a wider room for risk management and wealth creation.

 

Every single economy comes with a wide variety of investment opportunities. For instance, while Indian economy is dominated by Information Technology and Oil & Gas, international markets like the US are driven by Artificial Intelligence, industrial automation, and block chain. So foreign portfolio investment provides the investor with a greater exposure to both old and digital economy themes. It also offers freedom to the investor for wider asset allocation.   

 

Benefits Of International Portfolio Investment

 

Here are some of the benefits of international portfolio investment worth considering before taking the plunge.

 

Mitigation Of Both Depreciation and Volatility Risk

 

A well-diversified foreign portfolio mitigates investment risk. If the domestic assets in a portfolio underperforms, it can be compensated by the gains in the foreign investments in the portfolio. A good symmetry between assets from both developed and emerging markets in an international portfolio is a great hedge against the uncertainty in the domestic investment sphere. 

 

Diversification of Currency Value Risk

 

An investor purchases stocks, bonds or other assets in an international portfolio using the currency of the respective country. For example, if an investor purchases shares in London Stock Exchange, he uses British Pound as the medium of transaction. Thus, the ups and downs of British Pound can bring volatility to the value of the stock he purchased. The volatility of the US dollar, in general, affects every international asset in a portfolio across the globe. The investments made in different currencies in different countries can mitigate currency value risk.  

 

Varying Market Cycles

 

Market cycles vary in different countries or economies. An avid investor who manages an international portfolio can take advantage of this varying market cycles. An investor who identifies market tops or overvaluation in US stocks or dollars can divert his investments to developing economies like Latin America or Asia. It can aid capital inflow and supply-demand factors in that economy as well.    

 

A Well-Diversified Portfolio

 

Foreign portfolio investment offers a unique opportunity for the investor to diversify the portfolio assets on a global scale that, in turn, empowers the portfolio to achieve a higher risk-adjusted return. The macroeconomic factors that drive the financial markets all over the world vary at any given time. This factor gives lesser volatility for a portfolio with foreign investments than the one which focuses only on domestic assets.  

 

A Wider Credit Base

 

A foreign portfolio investor has access to credit sources of the foreign countries in which he has investments. It can be greatly beneficial when his domestic credit sources turn expensive or unavailable. The availability of the credit determines the ability of a business to expand its operations and to invest in new projects.  

  

Exchange Rate Benefits

 

Currency exchange rates fluctuate every single second, seven days a week, 365 days a year, all over the world without a holiday. The currency rates can turn weak or strong in accordance with ever-changing global political and economic factors. A foreign portfolio investor can greatly benefit from the stronger currency exchange rate of the foreign country in which his portfolio operates.

 

A Wider Market

 

Wider the market, less the competition and volatility. Domestic markets are highly competitive as most of the companies offer similar products and services. On the other hand, foreign markets offer wider headspace for the investor and lesser competition for the companies that gives away greater opportunities for diversification.  

 

Liquidity

 

The easy buying and selling of an asset in a portfolio is carried out by the liquidity offered by the cash market. Higher liquidity boosts the buying power of investors. Foreign portfolio investors are blessed with higher liquidity offered by international cash markets. A ready cash flow enables a foreign portfolio investor to tap a profitable investment opportunity as soon as it arises.  

 

Risks of International Diversification

 

Nothing comes without a risk in the portfolio management universe. The trump card of an investor that determines the success or failure of his investments including international portfolio investment is his risk management skill.

 

Here are some of the risks associated with international portfolio investment and how to tackle it.

 

An Efficient Flow of Information.

 

The flow of information plays a critical role in an information age. Financial markets in developed nations like the US have very efficient information flow. As a result, active market funds, most of the time, fail to consistently outperform the benchmark.  

 

Standard Poor’s Index Versus Active (SPIVA) 2020 report states that active large-cap funds have underperformed the S & P 500 for the past 11 years in a row. It not only brings greater risk of depreciation but also carries higher cost.  

 

To eliminate the depreciation risk and bring down the transaction cost, passive investment products like Exchange Traded Funds or an ETF would be better suited as an asset in a foreign portfolio. Further, passive investments mitigate the fund manager risk that can result in underperformance. It also provides an opportunity for an investor to invest a large amount of money through mutual fund route or as little installments through Systematic Investment Plans (SIP) or Systematic Transfer Plan (STP).

 

Political and Economic Instability.

 

Political and economic scenarios change with the countries. Developing or emerging countries don’t have the similar political and economic stability of developed nations. A political coup, civil war or a rumour of a Ponzi Scheme can bring 50% drawdown in an international portfolio. Many risk-averse investors can’t tolerate the political and economic instability in many countries all over the world.  

 

Higher Transaction Costs

 

Higher commission and brokerage charges along with taxes, stamp duties and exchange fees should be paid by the investors when they buy and sell international financial assets in their portfolio. It can reduce the overall returns of the portfolio. 

 

Again, mutual funds or ETFs come to the rescue. These financial assets can significantly reduce or eliminate higher transaction costs in an international portfolio.

 

An investor who deals with foreign portfolio investment should be aware of his investment objective and risk profile. A fund that aligns well with an investor’s investment objective and risk profile offers lower risk and higher returns.

 

Justin Raj

 

Alpha Research