Like any investment, international markets present a certain level of risk. But they also afford opportunities investors can’t access at home – and they’re no less manageable than those investors would find at home, if they understand them.
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., breaks down some of the risks involved in international investing, and how investors can try to mitigate those. Answers have been edited for brevity and clarity.
The Financial Pipeline: We’ve discussed the draw of international investing and the importance for Canadians to diversify their holdings beyond Canada. But like all investing, these markets must include some risks investors need to be aware of. Can you tell us about those?
David Pong: International investing does entail some level of risks, which aren’t so much unique as they are perhaps less familiar to Canadian investors. They are also dependent on the impact of different macroeconomic conditions and capital markets in foreign markets. Key ones associated with investing abroad include transaction costs (or costs associated with foreign investments, including higher brokerage commissions, management fees, stamp duties, withholding taxes and other trade-related levies), which are generally higher than what we see for domestic investments in Canada. It’s also important to consider currency volatility. As foreign investments typically require funds to be converted into relevant foreign currencies to purchase them, short-term fluctuations in their exchange rates relative to the Canadian dollar will either positively or negatively affect the value and returns of unhedged foreign investments at any given time. This risk has been particularly relevant in recent years with the strong U.S. dollar driving many global currencies lower. There is also liquidity risk. There are varying levels of market liquidity outside of Canada or the U.S., especially in emerging markets, where there can be an inherent risk of not being able to sell or exit an investment as easily or cost effectively, due to lesser developed capital markets or potential economic and political uncertainty. And of course, there are other typical country risks that you would expect from each foreign market, including informational, economic, legal/regulatory, political, and sovereign risks, the nature of which may differ substantially from the same type of risks in Canada.
FP: How can these risks be managed?
DP: The starting point in managing these risks is to appreciate that, while it is natural to feel hesitant towards approaching unchartered territory, there is sound basis for international investing and attractive opportunities that come with diversifying abroad. As with all things, doing your homework is crucial. Thorough research and analysis are recommended well ahead of making investments, as well as regular monitoring of markets thereafter. When making the investments, it is important to diversify them across multiple regions, countries, and even sectors to mitigate concentration risk. Also, while it is possible to hedge currency risk using, for instance, options and futures, hedging this exposure may not necessarily be advisable depending on currency outlooks. The costs to do so may also be prohibitively high for individual or retail investors. Staying unhedged or investing in other more cost-effective investment alternatives may make more sense. Finally, in parallel, seeking professional insights early in the process from a seasoned financial advisor who specializes in international investing and has access to localized market expertise is highly recommended to help navigate a portfolio through the inherent risks.
FP: You have a lot of experience investing in Asia. What are some opportunities you see in that region – and some considerations for anyone looking at that market?
DP: In terms of overall global investment strategy including Asia, I generally recommend a focus away from short-term trends and towards more medium- to long-term views, which means building a portfolio around key structural and secular themes. In my opinion, the best framework for medium- to long-term investment opportunities is what Brookfield refers to as the 3Ds: Digitalization, decarbonization and deglobalization – its guiding themes for global infrastructure investment. I would add to that a fourth D: demographic divergence (see breakdown here). We also often see the tendency to approach Asia as a single, monolithic market. In reality, it is a very diverse region, with highly varied stages of development. With this comes a fair share of complexity and contradiction. Many investment options out there take a strategy that leans toward a one-size-fits-all approach. That is a major pitfall and risk when it comes to investing in Asia. It is crucial for investors outside of Asia, and even within the region, to have a solid understanding and access to expert advice on local nuances and cultural sensitivities. You need a differentiated, tailored approach if you want to truly capitalize on the region’s upside and diversification benefits.
FP: For those who are able to understand (and find expert guidance) in these markets, what is the key draw? It is simply about spreading out risk and looking for ways to increase returns? Why is this something investors should explore?
DP: There are the different types of markets at varying stages of development and with varying levels of risk that can be invested in to make the most of many economic environments. Beyond the array across developed and emerging market exposures, international investing opens up access to key industries and leading players in sectors such as technology and healthcare, which are highly influential and tracked in global markets but have far less presence or availability in Canada’s equity market. While many international stocks from developed markets, including Canada, have exhibited a high correlation with the U.S. market (and each other) in recent years, this hasn’t always been the case historically. This was particularly true during periods of U.S. dollar decline or recession, a potential near-term risk that exists today. A weaker U.S. dollar tends to work in favour of international equities by making borrowing cheaper for foreign companies which, in turn, can help boost profits.
FP: Do you expect to see increased interest in these markets in the coming years, given the potential for economic decline in the U.S.?
DP: I do think international equities are likely to play an increasingly important role in investors’ portfolios over the next couple of years. Global diversification can hedge against concentration risk, cushion against a blow from market downturns here in Canada, reduce portfolio volatility, increase risk-adjusted returns, and provide an investment portfolio access to a wider variety of opportunities that are simply not available in the domestic market. The good news is that Canadian investors have been accelerating their exposure to foreign markets, particularly since the onset of the Covid pandemic, and that’s an encouraging trend.
Read more about how to invest internationally here.