4 Ways to Invest Internationally
Foreign stocks are again competitive with their domestic counterparts. Here are four ways to gain exposure.
What do Nestlé, Samsung, and Volkswagen have in common? Apart from being among the world's biggest companies, they're also all headquartered abroad.
"Many U.S. investors have this misguided notion that the S&P 500® Index is the be-all and end-all of the stock market," says Jeffrey Kleintop, Schwab's chief global investment strategist. "But if you're not investing abroad, you're missing out on more than half the global market."
Plus, after more than a decade of getting trounced by U.S. equities, foreign stocks are finally having their moment. From the end of October 2022 through the end of June 2023, the equal-weighted MSCI EAFE Index, which tracks developed markets abroad, was up more than 20%, whereas the equal-weighed S&P 500 was up just 6%. And international large-company stocks are projected to return 7.6% annually over the next 10 years, compared with just 6.1% annually for U.S. large-company stocks, according to an analysis by Charles Schwab Investment Advisory.
So, how much exposure to international stocks should investors have? "Probably more than they have currently," Jeffrey says. "After so many years of international underperformance, it's likely that many investors have let their allocations sag."
Even so, your degree of exposure should align with your overall goals and risk appetite. "Currency fluctuations, political events, and policy changes can negatively impact returns, with some types of investments more susceptible than others," Jeffrey says.
With that in mind, let's look at the benefits and risks of four common ways to incorporate foreign stocks into your portfolio.
1. ETFs and mutual funds
One of the easiest ways to invest in a broad swath of international companies across countries and sectors is through an exchange-traded fund (ETF) or a mutual fund. Funds that track a foreign market index typically are the most cost-effective, but actively managed funds can respond to changing conditions in real-time and may be more attractive to investors concerned with the risks associated with investing internationally.
- Benefits: There are more than 1,700 global or international mutual funds1 and more than 700 of such ETFs,2 most of which are widely available. Whether you select an index fund or an actively managed fund, the research required generally is much less time-consuming than evaluating individual stocks.
- Drawbacks: Although index funds tend to have extremely low fees, there's very little potential for outperformance since their goal is to track, rather than beat, their underlying indexes. Conversely, the average expense ratio for actively managed equity mutual funds was 0.66% in 2022. Actively managed funds also tend to generate more taxable events than index funds since the assets in their portfolios are bought and sold more frequently, potentially triggering capital gains.
"Well-managed active funds may be effective at increasing your upside potential while limiting your downside risks," says Peter McIsaac, director and investment research generalist at the Schwab Center for Financial Research. "But outperformance over time can be challenging, so you have to make sure they're worth the extra costs."
- Schwab's Select List® (schwab.com/selectlist) can help you identify international ETFs and mutual funds for your portfolio.
- You can also search for international funds by logging in to schwab.com/ETFscreener or schwab.com/fundscreener, selecting Fund Category under the Basic Criteria dropdown, then selecting International Equity.
2. American depository receipts
Hundreds of international companies are available to trade on U.S. markets via American depository receipts (ADRs)—essentially receipts for shares of the foreign stock issued by U.S. banks, which are denominated and pay dividends in U.S. dollars. They can also be traded over the counter via a broker-dealer network.
- Benefits: ADRs provide exposure to foreign companies without having to trade on local exchanges or in local currencies. Companies whose shares are available as an ADR on a U.S. exchange generally must adhere to Securities and Exchange Commission (SEC) rules on information disclosure and financial reporting, providing more transparency than is generally available from overseas investments. ADRs traded over the counter are subject to fewer regulations and reporting requirements.
- Drawbacks: Many foreign stocks, especially those from smaller companies, are unavailable as ADRs, limiting your investment options. Additionally, liquidity for some ADRs may be low, which can affect bid/ask spreads and eat into profits. The institutions that issue ADRs may also charge quarterly or annual pass-through fees, which can further erode returns.
"ADRs are a nice option for investors who want direct access to individual companies without the hassle or complexity of trading on a foreign exchange in the local currency," Peter says (see "Direct foreign investments"). "And because they trade on U.S. exchanges, ADRs tend to be much more liquid and cost-effective than other options."
You can search for ADRs by logging in to schwab.com/stockscreener, selecting Universe under the Basic dropdown, then selecting International (ADR).
3. Foreign ordinaries
Foreign stocks that are unavailable as ADRs may be available to trade on the U.S. over-the-counter market; this is known as trading foreign ordinaries.
- Benefits: Trading foreign ordinaries can give investors access to a wider array of international companies without having to trade on a foreign exchange. Investors don't need to open a foreign brokerage or other specialized account to trade, and commissions, though usually higher than for ADRs, are typically lower than when buying foreign stocks directly through local markets. As with ADRs, foreign ordinaries are traded in U.S. dollars.
- Drawbacks: Foreign ordinaries in the over-the-counter market may not be as liquid as those trading on a local market exchange, which may lead to greater volatility in prices and wider bid/ask spreads. Trades may also be subject to a foreign transaction fee.
"If an international company you like isn't available as an ADR, foreign ordinaries are really your only option other than direct investment," Peter says (see "Direct foreign investments"). "That said, you typically need broker assistance to trade over the counter, which can come with hefty fees, so keep that in mind if considering this route."
4. Direct foreign investments
Shares of foreign companies that are not available as ADRs or foreign ordinaries may be listed on their local exchanges. Investors who want to trade international stocks in their local currencies can open a specialized global account if offered by their brokers.
- Benefits: You have a much wider selection for trading individual stocks overseas versus hunting for their U.S. versions. A Schwab Global Account™, for example, allows you to trade international stocks in more than 30 countries, with real-time online trading in 12 of those markets, including Australia, Hong Kong, and Japan.
- Drawbacks: When the U.S. dollar appreciates relative to that currency, the value of your investment may decline. (Conversely, if the U.S. dollar depreciates relative to that currency, your investment performance may experience a boost.) However, you'll generally pay foreign-currency-conversion fees to trade in a global account, as well as trading commissions. Also, be aware that each country has its own regulations. Some may impose controls that restrict currency conversions for overseas traders, meaning it can take time to access your funds, or a cap on equity holdings by foreign investors, limiting the number of shares or percentage of outstanding stock in which you're permitted to invest.
"A global account is for those investors who want to be very active in international stock markets and desire access to the full menu of investable options there," Peter says. "It requires a higher level of sophistication, but it can be fulfilling for those who are up to the task."
Learn more about Schwab Global Account at schwab.com/globaltrading.
"The past 10 years rewarded U.S. investors who overweighted domestic stocks, but that may no longer be the case," Jeffrey says. "To have exposure to the world's best companies, international has to be part of the picture."
Taxing foreign investments
How to avoid double taxation on income from overseas investments.
If you own foreign investments, you may owe foreign taxes on your earnings, which your broker pays on your behalf. But how do you ensure you aren't taxed a second time when you pay your U.S. taxes?
First, look to see how much foreign tax you paid, which will be listed on the Form 1099-DIV or K-1 schedules you receive.
Say your international investments generated $10,000 in dividends and you paid $1,000 in foreign taxes. If you're in the 32% tax bracket, you would owe an additional $3,200 ($10,000 × 0.32) in U.S. tax on those same dividends. So, next, decide which of the following two options is best for you:
- Claim a tax credit: You can reduce your U.S. tax bill by claiming a credit equal to the amount you paid in foreign tax ($3,200 – $1,000 = $2,200).
- Take a tax deduction: If you itemize, you can deduct the foreign taxes from your dividend income ($10,000 – $1,000 = $9,000) before calculating your tax liability ($9,000 × 0.32 = $2,880).
In most cases, you're better off taking the credit since it will reduce your tax bill dollar for dollar, whereas a tax deduction reduces only the amount of income subject to taxation.
What about multinationals?
Despite what you may have heard, the S&P 500 alone does not provide sufficient international exposure.
Roughly 40% of sales generated by S&P 500 companies come from outside the U.S. As a result, one school of thought believes investors can achieve adequate international exposure from their domestic investments.
"A multinational corporation will certainly provide some exposure to international markets, but it won't allow you to fully tap into some of the higher growth rates that are available overseas," says Michelle Gibley, director of international research at the Schwab Center for Financial Research. "When adding international exposure to your portfolio, it's better to opt for true foreign investments that can offer differentiated returns from your domestic holdings."
2"Release: Exchange-Traded Fund Data," ici.org, 06/29/2023.
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