Businesses operate all over the world, not just in the United States. Suppose you want to invest in a Japanese company. If you buy the stock directly in Japan, there are several extra steps.
First, you’d need to work with a broker-dealer that can access Japanese markets. Some U.S. broker-dealers offer international trading, but not all do, and the service may come with additional fees.
Next, you’d want to understand the basics of the Japanese markets. In Japan, the Tokyo Stock Exchange is similar to the New York Stock Exchange (NYSE) in that it’s a major exchange where large companies trade. Even so, there are operational differences. For example, the Tokyo Stock Exchange closes for lunch every business day between 11:30am and 12:30pm. If you needed to trade quickly during that window, you wouldn’t be able to.
FYI - American markets do not close for lunch.
After choosing a broker-dealer and learning the basics of the Tokyo Stock Exchange, you’d convert U.S. dollars to yen to pay for the shares. That conversion can create issues if:
This is where American Depositary Receipts (ADRs) come in. ADRs were created to make it easier for U.S. investors to invest in foreign companies without trading directly on foreign exchanges.
ADRs are created by domestic financial firms with foreign branches. Firms like JP Morgan (which created the first ADR in 1927) purchase large amounts of foreign stock that has strong demand in the U.S. Those foreign shares are then placed into an account, which is usually structured as a trust (we’ll talk more about trusts in a future chapter).
From there, the financial firm divides (“slices”) the account into many “receipts” representing the stock. These receipts are then registered with the appropriate regulator (SEC or state administrator) and sold to U.S. investors in U.S. markets.
In some cases, the foreign issuer works with the bank that creates and issues the ADR, essentially encouraging the ADR’s creation. A larger audience of investors is generally beneficial for issuers. If the issuer needs to raise additional capital later, it can consider selling additional securities both in its home country and in the United States. Greater investor awareness can translate into greater access to capital.
Luckily for investors, buying an ADR doesn’t require you to understand a foreign exchange, use a foreign broker-dealer, or convert your money into a foreign currency.
Honda Motor Corporation is an example of an ADR. Honda is based in Japan, and its stock primarily trades on the Tokyo Stock Exchange. However, Honda’s ADR (ticker symbol: HMC) trades on the NYSE and in U.S. dollars. Buying it is operationally similar to buying any other U.S.-listed stock.
Although ADRs look and feel like other U.S.-traded stocks, they have some unique characteristics.
First, most ADRs do not provide voting rights. Because the underlying shares are technically owned by the financial firm that created the ADR, the ADR investor typically isn’t treated as the direct owner of the foreign shares. It’s also simpler for the financial firm to handle voting, especially when voting materials and procedures are in a foreign language.
ADR investors do not receive pre-emptive rights, but they are compensated for their value. The financial firm that created the ADR receives the rights if they are issued. Those rights are then liquidated in the foreign market at their current market price, and the proceeds are allocated to ADR holders as dividends.
Like common stockholders, ADR holders have the right to receive dividends, but there’s an added risk to understand. When the issuer declares a dividend, it pays the dividend in the foreign currency. The financial firm that created the ADR then converts that dividend into U.S. dollars.
Even though the investor receives the dividend in U.S. dollars, the exchange rate may move in an unfavorable direction before conversion. That’s why ADRs are still subject to currency exchange risk.
In addition, the foreign government may withhold part of the dividend for tax purposes. If this happens, the IRS provides a tax credit to investors for foreign tax withholding.
To summarize, ADRs make it possible to invest in foreign companies through U.S. markets using U.S. dollars. They simplify the trading process, but they still come with ADR-specific features and risks.
Beyond ADRs, investing in foreign securities used to be a cumbersome process. It’s generally much easier today. Many brokerage firms allow customers to invest directly in foreign stocks and bonds, and nearly every firm offers foreign exposure through securities like mutual funds and ETFs. Regardless of the method, foreign investing comes with its own benefits and risks.
A major benefit is diversification. If you owned only one stock in your entire portfolio, you could lose everything if that company went bankrupt. To reduce that risk, investors often spread money across many securities, industries, and regions. This helps balance a portfolio.
In 2018, the energy sector (natural gas, oil, etc.) was the worst performing sector, down more than 20% by the end of the year. If all of your money was invested in energy stocks, you would’ve lost a considerable amount of money. However, the health sector (pharmaceuticals, medical technology, etc.) was up over 4% over the year (2018 was not a great year in the stock market; in fact, the S&P 500 was down over 6%). By having some money invested in the health sector, losses from energy could be balanced by gains from health. This is diversification.
Foreign securities can also help diversify because there have been periods when domestic investments underperformed foreign investments. If the U.S. economy is in a recession, losses could be balanced by exposure to foreign investments.
Depending on the country and investment, additional risks may apply. Foreign investments in large, stable economies (like Japan or Germany) are generally considered safer than investments in smaller or less stable countries. Investments in companies or organizations from smaller, but growing economies are referred to as emerging markets.
Countries like Mexico, Thailand, and South Africa are considered emerging markets. While these countries haven’t historically been major players in the global economy, their economies are growing and gaining momentum. Investments in emerging markets can involve substantial risk. Many of these countries face governmental issues (corruption, “red tape,” etc.), economic problems, and weaker infrastructure for business.
For example, Venezuela has a history of nationalizing businesses, meaning the government takes over a private company and claims it as a public good. If you owned stock in a foreign company and it was nationalized, you could lose an immense amount of money and/or opportunity. You were the owner, but now the foreign government is. This is one risk that can arise in emerging markets.
While these investments can have meaningful downside risk, they can also offer significant profit potential. If investors can tolerate the volatility that often comes with emerging market investments, there’s a history of significant profits in this area. Plus, smaller economies have more room for growth, which can create more opportunities for returns.
Another risk of foreign investing involves currency. To invest directly in foreign companies and/or organizations, you typically must convert currency. For example, investing directly in a Japanese company would require converting U.S. dollars to Japanese yen. At the time of conversion, the exchange rate can either help or hurt the investor.
A weak currency can be beneficial or detrimental, depending on the situation. A weak domestic currency works against an investor when buying a foreign investment because it buys less of the foreign currency. Here’s a real-world example:
| Date | $1 US Dollar buys |
|---|---|
| June 2015 | 125 Japanese yen |
| November 2019 | 110 Japanese yen |
From June 2015 to November 2019, the U.S. dollar weakened against the yen, meaning one U.S. dollar bought fewer yen in 2019 than it did in 2015. When this happens, Japanese investments become more expensive for U.S. investors.
Using these numbers, assume a Japanese investment costs 15,000 yen per share. Here’s the difference in price when the only change is the exchange rate:
| Date | Cost of ¥15,000 in USD |
|---|---|
| June 2015 | $120 per share |
| November 2019 | $136 per share |
Even though the investment still costs ¥15,000, the U.S. dollar cost is higher in 2019 because the U.S. dollar weakened. This is an example of currency exchange risk, which occurs when a currency conversion negatively affects an investment. Here’s the math behind the numbers above:
June 2015
November 2019
A weak U.S. dollar works against American investors when purchasing a foreign investment. However, it works in their favor when selling a foreign investment and converting back to U.S. dollars. If the investor sells the ¥15,000 Japanese investment, they would net $136 per share in November 2019, compared to $120 per share in June 2015.
As you can see, a weak currency can produce different outcomes depending on what you’re doing (buying or selling). Here’s a summarization of these points:
Weak domestic currency
Similar to a weak currency, a strong currency can be beneficial or detrimental, depending on the situation. From November 2011 to November 2019, the U.S. dollar strengthened against the Japanese yen:
| Date | $1 US Dollar buys |
|---|---|
| November 2011 | 75 Japanese yen |
| November 2019 | 110 Japanese yen |
When the U.S. dollar buys more yen, it’s less expensive (in dollars) to make a foreign investment. Converting dollars to yen yields more yen, which allows the investor to buy more of the Japanese investment.
| Date | Cost of ¥15,000 in USD |
|---|---|
| November 2011 | $200 per share |
| November 2019 | $136 per share |
In November 2019, a ¥15,000 investment cost $136 per share, which is much cheaper than the $200 per share cost for the same ¥15,000 in November 2011. A strong currency is favorable when buying foreign investments. Here’s the math behind the numbers above:
November 2011
November 2019
A strong currency also has a downside. If you sell a foreign investment when your domestic currency is strong, you receive fewer dollars when converting back. Selling a ¥15,000 investment netted $200 per share in November 2011, versus netting $136 per share in November 2019. This is another example of currency exchange risk.
Again, currency strength can produce different outcomes depending on whether you’re converting into or out of the foreign currency. Here’s a summarization of the consequences of a strong currency:
Strong domestic currency
Here’s a video that breaks down foreign currency risk further:
Series 65 test questions may involve foreign investments and currency strength. While foreign investments can improve diversification, they also add complexity when currency conversions are involved. Depending on the strength of the currencies involved, the investor may increase or decrease their overall return.
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