While most investors understand diversification is key to a successful portfolio, all too often, Canadian investors seem wary of putting their money too far from home – and that can lead to missed opportunities and increased risk.
The Financial Pipeline spoke with David Pong, a global capital markets and investment expert whose most recent role was head of debt capital markets and head of sustainable finance for Asia-Pacific at SMBC Nikko Securities Inc., about the draw of investing in international markets and what investors need to consider if they wish to get into these markets, or increase their exposure to them. Answers have been edited for brevity and clarity.
The Financial Pipeline: Is international investing reserved for very wealthy or experienced investors, or are these markets any investor can explore?
David Pong: International investing is not the exclusive domain of sophisticated institutional investors or high net worth clients. The truth is that international investing should play an important part of all investors’ strategies to ensure more dynamic, diversified, and resilient investment portfolios. This is especially important for Canadians, as investing only in Canada means investing in a very small proportion of global GDP – just over three per cent of the world’s equity capital markets – and even less of the world’s bond markets. What’s more, the majority of that three per cent is concentrated in the energy/resources and financial sectors. As such, investing only in Canada amounts to essentially having all your eggs in one financial basket. Global diversification can protect against this sort of risk and provide an investment portfolio with potentially higher expected returns through access to a wide variety of attractive opportunities in different asset classes, geographies, and sectors within the remaining 97 per cent of the global equity market.
FP: Is diversification the main reason why investors should consider investing internationally?
DP: The principal underlying rationale for investors to broaden their portfolios to include international exposure is diversification, which is the key golden rule for investing in general. But it’s not the only reason. Canadian investment portfolios have historically been heavily tethered to a home bias, which is understandable but can put them at greater risk if the domestic economy falters. While Canada can be a very attractive place to invest, the average Canadian has approximately 50 to 60 per cent of their stock investments in domestic equities and 90 per cent of their total assets tied to Canada if you include a home, savings, investments, employment income, and pensions. That’s a lot of concentration risk. Global equities have historically been less volatile than Canadian equities, implying that cross-border diversification is beneficial. Another important motivation to invest internationally over the long term is that valuations may be more attractive overseas, especially if a portfolio is currently overweighted with U.S. equities exposure, as many portfolios currently are. Cheaper overseas valuations suggest good potential to deliver above-average returns in the long term. Investors should also consider such foreign investments as a way to hedge portfolios against a potential U.S. stock market pullback, especially as U.S. policymakers weigh an end to years of extraordinary economic stimulus, amid expectations for stabilizing growth, inflation, and employment trends in the coming months. International investing also allows access to broader investment options to get a foothold in regions and sectors of the global economy that are underrepresented in the domestic Canadian market.
FP: What kinds of markets are we talking about investing in when we talk about investing internationally?
DP: Generally, foreign markets can be divided into three different risk categories: Developed, emerging, and frontier markets. Developed markets are the large, safer and politically stable economies with well-developed economic, infrastructure, and governance systems – the U.S., the UK, and Japan, for example. These markets have a relatively high standard of living and are safer places to invest. However, many of these markets feature slower expected growth and stretched equity market valuations currently. Emerging markets are the lesser developed economies, some of which may exhibit more economic volatility and political uncertainty. However, they can often provide better investment returns given rapid growth, higher consumption, and favourable demographic trends. They include Brazil, China, and India – which are some of the world’s fastest growing economies. Frontier markets are even smaller and lesser developed economies than emerging markets, typically with considerable foreign investment restrictions. They can be quite risky, yet they can potentially offer outsized returns for undertaking that risk. Examples of frontier markets include Nigeria, Slovenia, and Vietnam.
FP: If those are the markets you can invest in, what are the actual investments you can make?
DP: One of the simplest ways to gain exposure abroad is to invest in international equities or fixed income mutual funds, with choices made based on your risk tolerance and investment preferences. Many Canadian mutual fund providers offer foreign mutual funds in unhedged U.S. dollars, although these tend to have higher fees. Exchange-traded funds (ETFs) are also a convenient way to invest in foreign markets. They are generally offered at lower fees than mutual funds, given their passive indexed approach. Like mutual funds, there are plenty of options, with some funds focused on single countries, while others cover broader geographic regions and sectors. Another option is direct investments. Many international markets, including specific foreign companies, are accessible directly through brokerage trading services, although this is typically a much more complex and costly alternative for the average individual investor unless the investments involve large sums of money. Foreign exposure can also be gained by investing in Canadian or U.S. companies that have operations and related companies generating a significant portion of their revenues internationally. However, this indirect approach is generally a suboptimal strategy to achieve the intended benefits of international investing. For most people, investing internationally through mutual funds or ETFs will be the easiest option. Those give you the benefits of diversification, and it’s generally cheaper and easier, since you don’t have to worry about the costs and timing considerations involved in trading on international exchanges or through American Depositary Receipts.
FP: How much should be invested internationally and how much should be allocated between the different types of foreign markets?
DP: Ultimately, the right allocation mix will depend on each individual investor’s unique risk profile, needs, and objectives, among other considerations. For most Canadians, it makes sense to maintain a larger portion of domestic assets in their investment portfolios because Canada is where they live and spend most of their time. A sense of security from investing in the familiar shouldn’t be undermined. However, a broadly diversified global portfolio has the potential to smooth out and enhance the Canadian investment experience by reducing the risk of losses and increasing potential returns over the long term. As a rule of thumb, for the foreign portion of an investment portfolio, it is generally advised that a minimum allocation of 40 to 50 per cent towards international exposure provides better potential for meaningful diversification and improved risk-adjusted returns. This allocation should be potentially as much as 60 to 70 per cent, if the goal is for greater U.S. exposure within the foreign portion – and if you expect to be spending a lot of time abroad. Within the foreign portion, there is compelling rationale to allocate about 10 per cent of a total investment portfolio towards a diversified emerging markets exposure to align with how much these markets represent of total global market capitalization. And as these markets grow rapidly, as they are poised to do, I would certainly recommend that this allocation be increased over time, in line with that growth. All that said, individual investors should consult a qualified investment adviser to determine the proper mix that is suitable for them.
Read more about the risk involved in international investing and how to mitigate it here.
