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Investing Overseas

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From Ranga Chand's Getting Started with Mutual Funds

With Canada representing less than 3% of the world's stocks and bonds, it makes very little sense to ignore the tremendous investment opportunities in the global marketplace. That would be like doing all your grocery shopping at the corner store. Sure, it is convenient and familiar, but it does not stretch your dollar very far. By shopping for securities worldwide, you effectively stretch those investment dollars. Until the advent of mutual funds, however, these markets were out of reach to many investors.

Over the past few years, the number of international mutual funds has mushroomed in Canada, from less than 50 in 1985 to nearly 500 in 1995, as mutual fund companies tempt investors with the promise of higher returns in a variety of marketplaces. These include funds that offer high-interest income with the potential for capital growth and currency gains, and funds that offer the opportunity for higher long-term returns through wider diversification in international equities. Investors can now take their pick from funds with assets in a particular region, such as Europe, Asia, or the Pacific Rim, or a particular country, like China or the United States.

Although most commonly referred to as international funds, these funds fall into two different categories. International funds invest worldwide, excluding Canada. Global funds, on the other hand, invest around the world, including Canada.

Benefits of Investing Abroad

By now, you know that one of the major advantages of investing in mutual funds is diversification. By diversifying, you reduce risk, and by diversifying worldwide, you reduce that risk further. World markets do not all march to the beat of the same drummer. By investing in equity funds that hold assets in various countries or regions, you can take advantage of these different market timings. While Canadian markets may be performing poorly, overseas markets may be booming. Let's say you invest $20,000 solely in Canadian equities and the market declines 20%. You suffer a capital loss of $4,000. If instead you invest $16,000 in Canada and $4,000 in overseas equities, your capital loss is only $3,200, and any gains in overseas markets will reduce this loss further.

Moreover, returns on the Toronto Stock Exchange over the past ten years have never been at the top of the leader board. While we have been congratulating ourselves on returns of over 30% in 1993, stock markets in Germany, Norway, the United Kingdom, Brazil, Hong Kong, and Singapore significantly outperformed the Toronto Stock Exchange's 300 Composite Index -- in some cases by as much as 100%.

The Added Risks

Investing internationally is not without its potential pitfalls. International funds are affected by the same risks as Canadian mutual funds and, in addition, are also sensitive to currency-exchange factors. When the Canadian dollar goes down in value against a country your fund holds assets in, you gain. When the Canadian dollar goes up in value against a country your fund holds assets in, you lose. If your overseas fund gains 15% but the Canadian dollar goes up in value against that currency by 10%, your actual gain will be (very roughly speaking) reduced to 5%. Moreover, if the Canadian dollar goes up in value and the markets in the country of investment are declining, you will take a double whammy. How successful a fund manager is in managing these different factors will have a direct effect on your returns.

The Different Types of International Funds

Like their domestic counterparts, funds that invest over-seas fall into three main categories: money-market, bond, and equity.

International Money-Market Funds. These funds, like their Canadian counterparts, invest in high-quality and highly liquid short-term (maturing in less than one year) money-market securities issued by governments, financial institutions, and blue-chip corporations. While the majority focus on the U.S. money market, a few spread their wings and invest in short-term securities globally. Investing in international money-market funds provides investors with the opportunity to take advantage of higher interest rates elsewhere and serve as a hedge against a drop in value of the Canadian dollar.

To see how this works, assume that C$1 = US$0.80 and you purchase units in a U.S. money-market fund worth US$500. The cost to you will be C$625. If the Canadian dollar fails to US$0.70, and you decide to sell, you will receive C$714.29, for a capital gain of C$89.29 plus any accrued interest. Of course, if the Canadian dollar strengthens against the U.S. dollar, and now C$1 -- US$0.90, you will receive only C$555.55, and incur a capital loss of C$69.44. Any interest earned will help offset this loss. U.S. money-market funds also provide investors with ready access to U.S. dollars.

Returns on these funds tend to cluster in a narrow band, with at most a one-percentage-point spread between the fund with the highest return and the one with the lowest. Clearly, no-load U.S. money-market funds with the lowest management expenses will have the edge.

For investors who wish to venture further afield, there are a few funds that invest in interest-bearing securities denominated in a variety of currencies such as the British pound, the French franc, and the German Deutschmark. Diversifying in this way reduces the risk inherent in investing in only one country and currency.

Interest income from international money-market funds is usually distributed monthly or can be automatically reinvested in additional fund units. By investing in Canadian short-term debt that is denominated in foreign currencies, several international money-market funds are 100% RRSP eligible. The remainder are eligible only to the current 20% foreign-content limit.

International Bond Funds. The primary objective of international bond funds is to provide a combination of fixed income and the opportunity for capital appreciation by investing selectively in government and corporate bonds worldwide. These funds seek opportunities around the world by investing in countries where interest rates are high and in those where there is the prospect of capital appreciation due to falling interest rates. (See Chapter 9 for more on bonds and interest rates.)

Unlike Canadian bond funds, these funds are denominated in foreign currencies and are subject to currency risk. This means that if the Canadian dollar falls against the other currencies contained in the fund portfolio, the value of the foreign bonds rises in terms of the dollar. As a result, the fund realizes a capital gain, which boosts its total rate of return. For example, if a bond fund earns 100 (100 pounds sterling), and assuming C$1 = 0.50, you make a capital gain of C$200. If, however, the Canadian dollar rises in value, and C$1 = 0.75, the fund experiences a capital loss. Your 100 is now worth only C$133.33.

Like their Canadian counterparts, international bond funds are interest-rate sensitive. When interest rates are rising in the country or region your fund holds assets in, bond prices drop. Conversely, when interest rates are falling, bond prices rise. For international bond funds, the best-case scenario is falling interest rates in the country of investment and a falling Canadian dollar. You'll be smiling all the way to the bank! The flip side is, of course, that if interest rates are rising in the country of investment, and the Canadian dollar also rises in value, the value of your investment may fall dramatically.

The average return for international bond funds over the five-year period to December 31, 1995, was 9.5%, and returns ranged from a high of 11.1% to a low of 8.3% -- a difference of 2.8%.

Enthusiasm for international bond funds has grown dramatically in recent years. To give you an idea of the number of investment dollars we are talking about, there were only five funds before 1990, managing about $100 million in assets, but by 1995 this figure had soared to over $5 billion.

International Equity Funds. Typically, assets in international equity funds are invested in shares of companies in both the developed economies of North America and Europe and also the rapidly developing countries, also known as emerging markets, of Southeast Asia, Latin America, and Africa. Regardless of where they invest, the primary objective of these funds, like their Canadian counterparts, is to provide investors with long-term capital appreciation.

Returns on these funds will be affected by factors such as market conditions, political uncertainties in the country or region of investment, and exchange-rate fluctuations. The value of many of these funds may fluctuate widely and it is important to be aware of this before you buy. Emerging markets can quickly turn into "submerging markets." International and global funds spread their risk, however, by diversifying investments on a worldwide basis. This way, they are able to take advantage of high-growth regions as well as exploit the timing of stock-market cycles in different countries. As a result, these funds tend to be less volatile than international equity funds that invest in one country or region of the world. The majority of these funds are RRSP eligible up to the current 20% foreign-content limit.

The average return for international equity funds over the five-year period to December 31, 1995, was 12.9%, and returns ranged from a high of 23.9% to a low of 4.0% -- a difference of 19.9%.

International Balanced Funds. The aim of these funds is to provide long-term capital growth plus regular income by investing in a combination of stocks, bonds, and short-term securities in different countries and industries around the world. A typical asset mix of 60% bonds and 40% stocks would change according to market conditions and the preferences of the portfolio manager. Generally speaking, international balanced funds are less volatile than international equity funds but more volatile than international money-market funds.

The average return for international balanced funds over the five-year period to December 31, 1995, was 10.8%, and returns ranged from a high of 14.6% to a low of 3.8% -- a difference of 10.8%.

A Final Word

Investing worldwide provides investors with additional diversification, a hedge against a decline in the Canadian dollar, and the opportunity to take advantage of different market timings. Investors should, however, be aware of the exchange-rate risks and the volatility in returns associated with many of these funds. Moreover, management expenses are higher for international funds, due to the added cost of having overseas advisers and operating in foreign markets.

Key Points to Remember

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