International Portfolio Investment
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International portfolio investment has become increasingly important as a result of changes in the global economic and political environment. Sohnke M. Bartram and Gunter Dufey studied the advantages and risks involved in investing internationally. As emerging markets, in particular, have become more accessible, they have begun to offer seemingly attractive investment alternatives to investors around the globe. International capital flows also have been driven by a divergence in population trends between developed and developing countries.
Mature, industrialized countries today are characterized by aging populations with significant needs for private capital accumulation. The underlying demand for savings vehicles is further reinforced by the necessary shift from pay-as-you-go pension plans toward capital market-based arrangements. By the same token, developing countries with relatively young populations require persistent, high levels of investment in order to create jobs and raise living standards. All this provides significant incentives for the growth of international markets for all kinds of financial claims, in general, and securities in particular.
The environment has become more conducive to international portfolio investment (IPI), and the potential benefits for savers and investors have lost none of their fundamental attractions. These benefits include the less-than-perfect correlation between national economies, the possibility of hedging an increasingly international consumption basket and the participation in exceptional growth opportunities abroad.
However, there is considerable controversy among investment professionals, both in academia and the financial services industry, regarding to what extent these intuitively perceived benefits of IPI are sufficiently significant. When the circumstances of the real world are taken into account, additional risks, costs and other constraints to IPI limit the potential advantages and, at worst, negate the benefits.
Two unique risks, which are analyzed in their paper, are currency (or exchange) risk and political (or country) risk, both of which are mitigated through diversification or choice of country. In addition, there are institutional constraints, particularly in the area of taxation. Taxes can be both an obstacle to and an incentive for IPI. They also discuss foreign exchange controls, capital market regulations, transaction costs and investors’ familiarity with foreign markets. Some of these concerns are mitigated by advances in technology and the adoption of more investor-friendly policies in many countries.
The research paper examines channels for direct international portfolio investment through the purchase of foreign securities in either the foreign or domestic market and for indirect investment through equity-linked Eurobonds, the purchase of shares of multinational corporations and international mutual funds.
The authors recommend that investors carefully consider the advantages and risks involved in international investing, including alternatives of using “global industry” funds to minimize risks. They conclude that investment opportunities are based on internationally segmented securities markets, which offer advantages for those who can overcome the barriers effectively. They further suggest that private investors consider buying country index funds and investing in shares of multinational corporations to achieve cost-efficient diversification benefits.
You can read the working paper at http://eres.bus.umich.edu/docs/workpap/wp01-006.pdf or contact Gunter Dufey at gdufey@umich.edu.