4 Questions to Ask When Investing in Foreign Stocks

Note: This article is part of Morningstar's December 2014 Guide to Better Investment Picking special report.

Imported goods are so ubiquitous in our lives that we hardly give them a second thought. As I sit in my home office, I'm clacking away on my laptop from a U.S. company and talking on a cell phone from a U.S. maker, too. But I'm not far from a Korean-made TV, and a Sony DVD player sits below it. And there can be little doubt that the plate I ate my lunch on was made in China.

Just as most imported goods are no longer even remotely exotic, investors are becoming increasingly comfortable with foreign stocks in their portfolios, too. In fact, even though U.S. stocks have generally performed better than foreign over the past five years, investors continue to invest heavily in foreign-stock funds, both diversified large-cap offerings as well as emerging-markets funds.

To make good decisions about your foreign-stock holdings, it's important to give some consideration to the amount of initial research and ongoing oversight you're willing to dedicate to your portfolio, how much volatility you're willing to tolerate, and whether you want to shoot for market-beating performance or are comfortable holding an index basket of foreign stocks (and the low costs that come along with such a strategy).

Thinking through the following choice sets can help you arrive at the right answer for you.

Choice 1: Will you invest in individual stocks or funds?
As with investing in U.S. stocks, your first decision when investing in foreign stocks is whether you will invest in individual stocks or in some type of managed product--a mutual fund, index fund, or exchange-traded fund. And as with U.S. investing, it's perfectly reasonable to do both, to invest directly in individual foreign stocks--especially blue chips such as American depositary receipts (ADRs), where trading costs are apt to be low and disclosure high--while employing funds to obtain exposure to less liquid parts of the international stock market. Here are the pros and cons of each tack.

Individual Stocks
Why: Investors in individual stocks have the opportunity to generate strong, even market-beating returns by concentrating their investments in a well-researched basket of individual stocks. Individual-stock investors can also avoid the management fees that accompany mutual funds and ETFs. But if they venture beyond American depositary receipts, which allow them to buy stakes in foreign companies trading on a U.S exchange, their transaction costs are apt to be higher than what they would pay for U.S. blue chips. Bid-ask spreads may also be large when purchasing securities on foreign exchanges, further increasing trading costs. Of course, such costs are also borne by funds, and in fact, foreign-stock fund expenses are generally higher than is the case with U.S. stock funds. But as larger entities, funds may more readily be able to benefit from economies of scale than individual-stock investors can.

Why not: Investors in individual stocks may have more concentrated portfolios than what they would be able to obtain through a mutual fund, and therefore, their portfolios' volatility could be higher. And if they venture beyond blue-chip multinationals, whose shares are listed on U.S. exchanges, individual-stock investors may find it difficult to thoroughly research prospective holdings: Different countries take varying approaches to shareholder disclosures. Costs may also be higher. This Securities and Exchange Commission alert details some of the key costs and risks that can accompany direct investment in foreign companies.

If you go this route for all or part of your foreign-stock exposure:Morningstar's philosophy for investing in stocks transcends geography. As with investing in the U.S. market, we believe that foreign-stock investors improve their chances of success if they focus on high-quality companies with sustainable competitive advantages--or moats--and aim to pay a reasonable price for them. This article highlights a few individual companies that fit the bill and also links to a screen for wide-moat, reasonably valued foreign stocks that could be worthy of future research.

Mutual Funds
Why:Whereas the investor in individual foreign stocks may have a difficult time researching and building a portfolio that's well diversified by geography, company size, style, and sector, an investor in a well-diversified mutual fund gets instant diversification. The fund investor can also rely on professional managers to do the heavy lifting on researching companies and navigating varying disclosure regimes.

Why not:Professional management entails costs, and foreign-stock funds typically charge even more for their services than U.S. stock funds do. That can cut into the returns investors earn on their foreign-stock holdings. Mutual funds can also foist unwanted capital gains on their shareholders, whereas individual-stock investors exert a higher level of control over capital gains realization. The taxes that foreign companies levy on their dividends can also end up denting some investors' returns, even though investors receive a tax credit for them, as Adam Zoll discussed in this article.

If you go this route for all or part of your foreign-stock exposure: Start with Morningstar Medalist funds to winnow down the universe to a more manageable group; our analysts believe these funds will outperform their peers in the future.

Choice 2: Will you buy an index fund or go with an actively managed one?
It's the $64,000 question for all investors who have decided to buy a mutual fund: Invest with a passive index tracker or go active? In the past, conventional wisdom was that international investing was a good place to go active, but international index funds are on the ascent. Index-based foreign-stock mutual funds have also been seeing strong asset inflows because their long-term returns have been competitive with--or better than--their actively managed counterparts. Here are the pros and cons associated with each strategy.

Index Fund
Why:Foreign-stock index funds give you broad exposure to the foreign markets (or segments of them) in a single shot, often at very low cost, enabling you to get away with a very minimalist portfolio. Thanks to their cost advantage relative to actively managed funds, as well as the fact that their trading costs are very low, broad-market index funds have generated long-term returns that are competitive with--or better than--the foreign-stock fund category average. Nor are strategy or management changes apt to be an issue with market-cap-weighted index funds. Broad-market equity index funds also tend to have good tax efficiency, meaning that they tend to make few capital gains distributions on a year-to-year basis. (Investors who own index funds in their taxable accounts will owe taxes on any dividends they receive, however.)

Why not: Although their returns are competitive with actively managed foreign-stock funds' returns, investing in an index fund all but ensures that you'll lag the benchmark by your fund's expense ratio. On top of that, index funds do not have the ability to retreat from dicey markets when the going gets tough, which is a technique that investors might value in a foreign-stock fund even more than in a U.S.-focused fund.

If you go this route for all or part of your foreign-stock exposure: Pick low-cost funds, because basic index funds are essentially interchangeable. It's also important to understand the index methodology. Morningstar's list of foreign-stock medalist funds includes a heavy complement of index funds. This article highlights some top core-type index funds for foreign-stock exposure.

Active
Why:At first blush, active management seems especially appealing for foreign-stock funds. Foreign-stock managers typically have wide discretion over their portfolios' geographic exposure, enabling them to emphasize more profitable regions and de-emphasize problem spots. Index funds, meanwhile, have no choice but to mirror their benchmarks' exposures. Because it's arguably harder to research foreign companies than it is U.S. companies, savvy foreign-stock investors may also be able to gain a performance edge by unearthing hard-to-come-by information about the companies in which they've invested.

Why not: As with U.S. equities, you'll typically pay a higher price for an actively managed foreign-stock fund than you will for an index product or ETF. Active funds also tend to incur higher tax and transaction costs than index products, because their turnover is also higher. Moreover, investing in an active fund requires more patience than buying a passively managed product, because active managers' styles will periodically fall from favor, sometimes for long stretches. Finally, active funds require more monitoring than index funds.

If you go this route for all or part of your foreign-stock exposure:Morningstar's medalist list includes a number of topnotch actively managed foreign-stock funds. In general, they're cheaper than their peers, boast long-tenured management teams that aren't shy about looking different from their competitors, and hail from firms that are strong stewards of shareholders' capital. This article calls out some of Morningstar's favorite actively managed foreign-stock funds.

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Choice 3: Will you emphasize emerging markets?
One of the other big decisions for foreign-stock investors is how much to invest in emerging markets, which tend to have higher volatility than developed foreign markets but also have higher growth and therefore, many investors assume, the potential for higher long-term returns.

Investors can approach this decision in a few different ways. Because emerging markets tend to have higher volatility than developed, they can circumvent emerging markets altogether--investing in an MSCI EAFE fund or an actively managed fund that systematically downplays emerging markets. On the flip side, if they're enthusiastic about emerging markets, they can layer on a dedicated emerging-markets fund or invest heavily in a diversified foreign-stock fund that buys heavily into emerging markets. As a middle ground, they can mirror the global market capitalization's weighting in emerging markets. Depending on the index and how it defines emerging markets, between 15% and 20% of overseas companies are currently domiciled in emerging markets. Here are the key pros and cons of emphasizing developing markets as a component of your foreign-stock portfolio.

Why emphasize: The key reason to invest in emerging markets is that economic growth rates have typically been higher than is the case with developed foreign markets. And because these markets are less liquid and still less heavily followed than developed, savvy investors may be able to sleuth out attractive opportunities that haven't been widely recognized by other investors. Emerging markets may also be subject to geopolitical and other market shocks that cause broad-market sell-offs. While not fun to go through, such downturns can translate into buying opportunities for savvy value investors.

Why not:Although economic growth has historically been higher in emerging markets than in developed, it has slowed in recent years. More importantly, there's no clear connection between GDP growth and market performance, and emerging markets typically feature higher volatility than developed foreign markets. The typical diversified emerging-markets fund has a 10-year standard deviation of 19, versus 24 for the average foreign large-blend fund. Shareholders in companies domiciled in emerging markets may also have fewer rights than shareholders in companies from developed markets.

If you emphasize emerging markets:Investors seeking emerging-markets exposure can take a few different tacks. They can invest with a diversified foreign-stock fund with a history of investing in emerging markets; they can buy a dedicated emerging-markets fund; or they can focus on a particular region within emerging markets, such as Latin America. Morningstar's medalist list homes in on top funds of all three persuasions, and this article calls attention to some of the best ones.

Choice 4: Will you hedge your foreign-currency exposure?
Another consideration for foreign-stock investors is what tack to take with foreign currencies. This is an important decision because, as a U.S. investor, your return from foreign stocks consists of two elements: any gains or losses in the securities of the portfolio, as well as any gains or losses in the foreign currency versus the dollar over the holding period. If the stock appreciates and the currency in which it is denominated appreciates relative to the dollar over your holding period, you win on both sides of the trade. But if the stock declines and the foreign currency declines, too, it's a lose-lose.

Because foreign-currency fluctuations can be a big component of a foreign-stock investor's return, some investors aim to erase, or at least reduce, foreign-currency effects using a technique called hedging. Senior analyst Gregg Wolper explores the details of currency hedging in this article. Here are the pros and cons of incorporating hedging into your foreign-stock-investing strategy.

Why hedge: There are a few key reasons one might hedge foreign-currency exposures. A key one is if you expect the foreign currency to decline relative to the dollar--in that case, you'd like to cut those foreign-currency effects out of your return. Another is if you know you're no good at predicting foreign-currency movements but instead want your return to be a pure reflection of the securities' return--you don't want any foreign-currency-related noise.

Why not: A key reason to maintain an unhedged portfolio is that foreign-currency swings can be a source of diversification for your portfolio. Another, perhaps even more persuasive reason not to hedge is that foreign-currency fluctuations are notoriously difficult to predict. And in any case, foreign-currency swings tend to balance each other out over long periods of time: Though the dollar has made strides relative to major foreign currencies over the past five years, foreign currencies are apt to enjoy their own day in the sun eventually. Finally, because foreign-currency hedging is typically accomplished by buying futures contracts, there are costs associated with doing so, which can cut into returns.

If you decide to hedge:There are a few different ways to hedge your foreign-stock portfolio's currency exposure. The most straightforward way would be to buy a mutual fund that does the hedging for you, such as  Tweedy, Browne Global Value (TBGVX). If you determine that you'd rather not hedge, you have a broad range of options from which to choose. Foreign-stock index funds never hedge their currency exposures, for example.

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