CHAPTER FIFTEEN INVESTING INTERNATIONALLY Practical Investment Management Robert A Strong Outline Motivation for International Investing Diversification Market Efficiency Growth Methods of Investing American Depository Receipts Country Funds Individual Securities Unit Investment Trusts International Mutual Funds South-Western / Thomson Learning © 2004 15 - Outline Emerging Markets Characteristics Rationale Investment Considerations Special Risks Country Risk Trading Costs Market Pressure Lack of Financial Information South-Western / Thomson Learning © 2004 15 - Introduction Insert Figure 15-1 here South-Western / Thomson Learning © 2004 15 - Motivation for International Investing Diversification: Portfolio risk reduction was the original motivation for international investing Now however, evidence indicates that this alleged advantage may be overstated South-Western / Thomson Learning © 2004 15 - Motivation for International Investing Market efficiency: Free lunches may exist in underdeveloped markets Growth: Many markets are less efficient than those in the United States South-Western / Thomson Learning © 2004 15 - Methods of Investing: ADRs An American depository receipt (ADR) is a marketable receipt showing ownership of a foreign security Large commercial banks issue ADRs as a convenience to would-be investors in foreign securities A sponsored ADR is issued in coordination with the underlying company South-Western / Thomson Learning © 2004 15 - Methods of Investing: GDRs Global depository receipts (GDRs) are issued in the Euromarket and are backed by the Euromarket depositories rather than by a specific bank In practice, the terms ADR, GDR, and DR are interchangeable They all improve a firm’s access to U.S investment capital South-Western / Thomson Learning © 2004 15 - Methods of Investing A country fund is a closed-end investment company whose portfolio is comprised almost entirely of securities issued within a particular foreign country The fund may contain some short-term domestic securities for holding temporary funds awaiting reinvestment Closed-end fund shares typically sell at a discount from their apparent “true” value South-Western / Thomson Learning © 2004 15 - Methods of Investing Individual securities: Individual and institutional investors may also purchase shares directly on a foreign exchange, especially if the exchange is well-developed A unit investment trust is a professionally selected, but unmanaged, portfolio of securities designed to meet some stated investment objective South-Western / Thomson Learning © 2004 15 - 10 Methods of Investing International mutual funds are portfolios of securities too They provide immediate diversification, professional management, and ease of entry and exit from the market An important consideration in selecting a mutual fund is the fee charged by the fund manager South-Western / Thomson Learning © 2004 15 - 11 Emerging Markets: Characteristics An emerging market is characterized by a low per capita gross national product History: Today’s developed markets were once emerging markets too Culture: Significant differences exist among emerging markets, but as a group, they share one primary similarity - change The stock market of an emerging country can be particularly volatile, especially by U.S standards South-Western / Thomson Learning © 2004 15 - 12 Emerging Markets: Characteristics Insert Figure 15-2 (Emerging Market Volatility) here South-Western / Thomson Learning © 2004 15 - 13 Emerging Markets: Rationale Adding value: Inefficiencies in developing markets provide opportunities for money to be made Reducing risk: While correlations among the developed markets are increasing, emerging markets show little correlation with developed markets or with one another Getting on the bandwagon: Current industry practice is another reason for the popularity of international investing South-Western / Thomson Learning © 2004 15 - 14 Emerging Markets: Investment Considerations Accounting information: Reliable accounting information is especially scarce in emerging markets Foreign currency risk: Hedging foreign exchange risk is complicated in emerging markets due to the less availability of hedging vehicles South-Western / Thomson Learning © 2004 15 - 15 Emerging Markets: Investment Considerations Fraud: Emerging markets carry a genuine risk of fraud, ranging from accounting misstatements to counterfeit securities or bucket shops Liquidity risk: Residents of a developing country typically have little money of their own to invest South-Western / Thomson Learning © 2004 15 - 16 Special Risks: Country Risk Country risk refers to a country’s ability and willingness to meet its foreign exchange obligations The two components to country risk are political risk and economic risk Political risk is a measure of a country’s willingness to honor its foreign obligations Economic risk is a measure of the country’s ability to pay It is largely a function of the income statement rather than of the balance sheet South-Western / Thomson Learning © 2004 15 - 17 Special Risks Foreign market investing is likely to involve trading costs at least one percent higher than investing domestically Market pressure can be an important trading cost in international markets, especially with small-capitalization stocks Lack of financial information: Some particular problems with financial information sources are inherent in emerging markets Often, accounting standards differ too South-Western / Thomson Learning © 2004 15 - 18 Review Motivation for International Investing Diversification Market Efficiency Growth Methods of Investing American Depository Receipts Country Funds Individual Securities Unit Investment Trusts International Mutual Funds South-Western / Thomson Learning © 2004 15 - 19 Review Emerging Markets Characteristics Rationale Investment Considerations Special Risks Country Risk Trading Costs Market Pressure Lack of Financial Information South-Western / Thomson Learning © 2004 15 - 20 ... Individual Securities Unit Investment Trusts International Mutual Funds South-Western / Thomson Learning © 2004 15 - Outline Emerging Markets Characteristics Rationale Investment Considerations... depositories rather than by a specific bank In practice, the terms ADR, GDR, and DR are interchangeable They all improve a firm’s access to U.S investment capital South-Western / Thomson Learning... the exchange is well-developed A unit investment trust is a professionally selected, but unmanaged, portfolio of securities designed to meet some stated investment objective South-Western / Thomson