A more connected global economy, widespread access to information, and deregulation in the financial markets have made it easier to diversify your investment portfolio without breaking the bank. For many investors, prudent diversification has meant more than balancing asset class exposure or carefully choosing different sectors or industries in which to invest.
Those in the United States looking to diversify may begin looking beyond the amber waves of grain to the capital markets of other countries and regions. Europe is a particularly attractive choice, as it is home to many of the world's preeminent corporations that have rewarded owners with decades of capital appreciation and dividends.
Here are four methods an investor, portfolio manager, or financial advisor may use to add European market stocks to a well-constructed basket of holdings.
Specialized Mutual Funds and Exchange-Traded Funds
This method of investing in European stocks is particularly useful for investors without a lot of capital. By investing in mutual funds or exchange-traded funds (ETFs) that restrict their components to companies that are headquartered—or do a large percentage of business—in Europe, you can get the benefits of widespread diversification at a lower cost than you otherwise might be able to get by attempting to build the positions directly.
Investing through a pooled vehicle such as an index fund, whether structured as a traditional mutual fund or exchange-traded fund, does come with some downsides. You often have significant unrealized capital gains that are lurking in the portfolio.
Though it's significantly less likely, there are scenarios under which you could end up paying substantial taxes on someone else's past gains (a technical point that most investors do not even realize exists with funds). Perhaps more pressing is the fact that you have to take the good with the bad, including dealing with the underlying sector and industry weightings of the fund portfolio.
American Depository Receipts
Another way to invest in the European stock market is to buy foreign stocks through American Depository Receipts (ADRs).
In some cases, American Depository Receipts are sponsored by the foreign company itself. In other cases, a depository bank, usually a subsidiary of a large financial institution, directly purchases a block of foreign stocks. Such a bank operates on the premise that there is a domestic market for these foreign stocks, and, in turn, fee income can be generated by offering access to them.
The bank puts these foreign stocks on its books and issues securities representing ownership of them, with those securities trading in the domestic market, usually on the over-the-counter (OTC) market. In turn, individual investors can buy and sell shares just as they might with domestic stocks: go online, enter the ticker symbol, review the trade, and submit it through a brokerage account.
A depository bank collects dividends, converts them to U.S. dollars, distributes them to owners of the American Depository Receipts, and then charges small fees on the ADRs. The depository bank often handles foreign tax treaty filings, so a 15% withholding rate (as opposed to the 35% rate) applies to dividends.
Dividend Yield Calculations
A challenge to consider when dealing with American Depository Receipts is that many financial portals do not specify if they are reporting the dividend and the dividend yield based on the gross pre-tax dividend—as is done with domestic securities—or on the net-of-tax dividend after foreign dividend withholding (and if the latter, at which rate).
If you want a true apples-to-apples dividend comparison between ADRs, you will need to do a little digging and make some adjustments to the figures.
Another drawback is that programs involving American Depository Receipts might be modified or changed in ways you did not anticipate. But, if this happens, you may be able to leave the program and take direct possession of the underlying foreign stocks. However, doing so might involve payment of a fee to a broker and the depository bank.
Direct Shares of European Stocks
This method is the most direct, though often the least familiar, to American investors who have only owned domestic securities. For the sake of illustration, let's say that you want to own shares of a large chocolate company in Switzerland.
The specifics of how you go about buying shares differ based on the brokerage firm you use to execute your trades. If you are a retail investor, check with the institution with which you have a brokerage account.
A brokerage should help you exchange U.S. dollars for Swiss francs for settlement, and it will also charge a spread and inform you of the final execution price and the commission amount. The commission amount will usually involve an additional commission for the local broker in Switzerland with which your broker has a relationship.
When the shares appear in your brokerage account, they will be shown without a ticker symbol (or with a ticker symbol that cannot be traded online). The shares will also be shown in the U.S. dollar equivalent, not the actual quoted price in Swiss francs.
As a result, they can appear to fluctuate wildly, even if they have not changed in quoted value on the Swiss stock exchange. The custodian (which is probably also your broker) will tell you what the stock would be worth if you sold the position and converted the resulting Swiss francs to U.S. dollars.
Equally as important, any dividends received in Swiss francs are going to be automatically converted to U.S. dollars and deposited in your brokerage account as a net spread (in light of the currency conversion). Foreign taxes to the government of Switzerland will also be withheld, usually at a rate of 35%.
To avoid this, you would have to go through the trouble of filling out a specific set of paperwork that claims your right as an American citizen, under a tax treaty between the United States and Switzerland, to opt for the lower 15% foreign dividend tax withholding rate. In rare cases, your custodian might be able to show the quoted value of the shares in Swiss francs and allow you to hold multiple currencies in your account so that the dividends also arrive in Swiss francs.
One drawback to this investing method is that it requires investing at least several thousand dollars per transaction. You may not technically need thousands of dollars to buy European stocks this way, but the added commissions and expenses will take a chunk out of your profits, and you can minimize their impact by trading in bulk.
You may also want to consider prioritizing buy-and-hold investments to minimize the currency exchange costs that make switching between positions expensive.
Domestic Investments With Significant International Market Exposure
Investors, particularly those new to investing in common stocks, may mistakenly limit the reach of a company to the country in which it is headquartered. A substantial number of U.S. firms already generate significant sales and profits internationally, and many others are looking to expand abroad. In 2018, for example, over 40% of sales for companies on the S&P 500 came from overseas. In this context, by investing in domestic blue-chip companies, you may already be investing in Europe without realizing it.