Businesses operate all over the world, not just in the United States. Suppose you want to invest in a foreign company - say, a Japanese company. Buying the stock directly can take extra steps.
First, you’ll need to work with a broker-dealer that has access to Japanese markets. Some U.S. broker-dealers offer international trading, but not all do. You may also pay additional fees for this service.
Next, you’ll want to understand the basics of the Japanese markets. In Japan, the Tokyo Stock Exchange is similar to the New York Stock Exchange (NYSE). It’s where stocks of larger companies trade. Even though the market structure is familiar, there are differences that can matter. For example, the Tokyo Stock Exchange closes for lunch every business day between 11:30am and 12:30pm. If you need to buy or sell quickly, that midday closure can be an issue.
FYI - American markets do not close for lunch.
After you find the right broker-dealer and understand the basics of the Tokyo Stock Exchange, you’ll convert U.S. dollars to yen to pay for the shares. This can create problems if the exchange rate is unfavorable (weak dollar or strong yen - see below for more on currency exchange risk) or if your broker-dealer charges significant conversion fees.
American Depositary Receipts (ADRs) were created to reduce these hurdles. 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 high 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. The receipts are then registered with the proper 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 investor audience 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 expand access to capital.
Luckily for investors who buy ADRs, there’s no need to understand how a foreign exchange works, deal with a foreign securities broker-dealer, or convert 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 similar to buying any other U.S.-traded stock.
Although ADRs trade like U.S. 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 shareholder of record for the foreign stock. It’s often simpler for the financial firm to vote the shares, 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 between the foreign currency and the U.S. dollar may be unfavorable at the time of conversion. That’s why ADRs are still subject to currency exchange risk even though the payment is made in U.S. dollars. In addition, the foreign government may withhold part of the dividend for tax purposes. If that happens, the IRS provides a tax credit to investors for foreign tax withholding.
To summarize, ADRs make it easier to invest in foreign companies by allowing you to buy and sell in U.S. markets using U.S. dollars. They still come with specific features and risks, including currency exchange risk.
Beyond ADRs, investing in foreign securities used to be a cumbersome process. It’s generally easier today, especially with digital trading platforms. Many brokerage firms allow customers to invest directly in foreign stocks and bonds, and nearly every firm offers exposure to foreign securities through products like mutual funds and ETFs. Regardless of the method, foreign investing has its own benefits and risks.
A major benefit is diversification, which is a key concept in investing. If your entire portfolio were invested in a single stock, you could lose everything if that company went bankrupt. To reduce that risk, investors often spread money across many securities, industries, and regions. That balance is diversification.
In 2018, the energy sector (natural gas, oil, etc.) was the worst-performing sector, down more than 20% by year-end. If all your money were invested in energy stocks, you would’ve lost a considerable amount. Meanwhile, the health sector (pharmaceuticals, medical technology, etc.) was up over 4% for the year (2018 was not a strong year overall; the S&P 500 was down over 6%). By holding some health-sector exposure, losses from energy could be partially offset by gains in health. That’s diversification.
Foreign securities can also help diversify. There have been periods when domestic investments underperformed foreign investments. If the U.S. economy is in a recession, losses in domestic holdings 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 forms of foreign investing. Investments tied to smaller economies can involve more risk. 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. Investments in emerging markets can involve substantial risk. Some of these countries face governmental issues (corruption, “red tape,” etc.), economic problems, and weaker business infrastructure.
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 a significant amount of money and/or opportunity. You were the owner, but now the foreign government is. This is one example of a risk that can arise in emerging markets.
While these investments can have meaningful downside risk, they can also offer substantial profit potential. If investors can tolerate the volatility that often comes with emerging market investing, there is 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 in 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 requires converting U.S. dollars to Japanese yen. At the time of conversion, the exchange rate can work for or against you. You’ve probably heard the terms “weak” and “strong” currency. Neither is universally “good” or “bad,” but each has consequences.
A weak currency can be beneficial or detrimental, depending on the situation. A weak domestic currency works against an investor who is buying foreign investments. When a currency is weak, it buys less of another 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. One U.S. dollar bought fewer yen in 2019 than it did in 2015. When this happens, it becomes more expensive (in dollars) to buy Japanese investments. 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 price is the same in yen (¥15,000), the cost in U.S. dollars 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 can work 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 will net $136 per share in November 2019, compared with $120 per share in June 2015.
As you can see, a weak currency can lead to different outcomes depending on what you’re doing. Here’s a summary:
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 can allow you 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 after conversion. Selling a ¥15,000 investment netted $200 per share in November 2011, versus $136 per share in November 2019. This is another example of currency exchange risk.
Again, currency strength can produce different outcomes depending on the transaction. Here’s a summary:
Strong domestic currency
Here’s a video that breaks down foreign currency risk further:
Series 66 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 exchange rates, currency movements can increase or decrease an investor’s overall return.
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