6 Ways to Invest in Foreign Stocks

Today's investing opportunities are not bound by geography. If you're intrigued by emerging economies and booming growth in markets around the world, you may want to invest in some of them.

For many investors, buying foreign stocks allows them to diversify by spreading out their risk, in addition to giving them exposure to the growth of other economies. Many financial advisors consider foreign stocks a healthy addition to an investment portfolio. They recommend a 5% to 10% allocation for conservative investors, and up to 25% for aggressive investors.

The Risks of Foreign Investing

International investing, however, has its flip side. In terms of volatility, emerging markets in general are considered riskier. They can experience dramatic changes in market value, and in some cases, political risk can suddenly upend a nation's economy. Furthermore, it should be noted that foreign markets can be less regulated than those in the U.S., increasing the risk of manipulation or fraud.

Today's investors have extraordinary access to 24-hour global news, yet there is also a risk of inadequate information from a market that is often thousands of miles away. This can limit the investor's ability to interpret or understand events.

Finally, there is currency risk stemming from changes in the exchange rate against the investor's home currency. Of course, currencies move both ways and can also be in the investor's favor.

If you're up for the opportunity and risk of international investing, there are six ways to gain exposure to growth outside the U.S.

1. American Depository Receipts (ADRs)

American depository receipts (ADRs) are a convenient way to buy foreign stocks. Foreign companies use ADRs to establish a presence in U.S. markets and sometimes raise capital. One example is Chinese e-commerce giant Alibaba (BABA), which raised $25 billion in 2014 (what was then the largest initial public offering) and listed its ADRs on the New York Stock Exchange (NYSE). 

ADRs can be a sponsored ADR or unsponsored ADR and have three levels.

• Level 1 ADRs can be used to establish a trading presence in the U.S., but cannot be used to raise capital. Because they are unsponsored, they can only trade over-the-counter (OTC).
• Level 2 ADRs can be used to establish a trading presence on a national exchange such as the NYSE, but cannot be used to raise capital.
• Level 3 ADRs can list on national exchanges in addition to being used to raise capital.

Each ADR that a foreign company issues represents an underlying share, or number of underlying shares. For example, one Vodafone Group (VOD) ADR represents 10 underlying shares, while Sony Corp (SNE) ADRs represent the underlying on a 1:1 basis. 

These ADRs are listed, traded, and settled just like shares of domestic U.S. companies. That makes them a convenient way for the average investor to hold foreign stocks.

2. Global Depository Receipts (GDRs)

A global depository receipt (GDR) is another type of depository receipt. A depository bank issues shares of foreign companies in international markets, typically in Europe, and makes them available to investors within and outside the U.S. Many GDRs are denominated in U.S. dollars, though some are denominated in euros or the British pound. They are typically traded, cleared, and settled in the same way as domestic stocks.

GDRs can be found on the London Stock Exchange and Luxembourg Stock Exchange, as well as on exchanges in Singapore, Frankfurt, and Dubai. GDRs are typically placed with institutional investors in private offerings before public trading.

3. Foreign Direct Investing

There are two ways for investors to buy foreign stocks directly. You can open a global account with a broker in your home country, such as Fidelity, E*TRADE, Charles Schwab, and Interactive Brokers. The other option is to open an account with a local broker in the target country. For example, the MONEX BOOM trading platform based in Hong Kong gives investors access to Hong Kong stocks in addition to 11 other markets.

Going direct is not suitable for the casual investor. There are additional costs, tax implications, technical support needs, research needs, currency conversions, and other factors to consider. In short, only active and serious investors should participate in foreign direct investing.

Investors need also to be wary of fraudulent brokers not registered with regulators in their market, such as the Securities and Exchange Commission (SEC) in the U.S.

4. Global Mutual Funds

Investors keen to explore global markets—but don't want much hassle—can opt for a mutual fund that focuses on international equities. Simplicity is one of the several advantages of mutual funds.

Internationally-focused mutual funds come in a variety of flavors, from aggressive to conservative. They can be region or country-specific. They can be an actively managed fund or a passive index fund tracking an overseas stock index. But be careful of fees: Globally focused mutual funds can have higher costs and fees than their domestic counterparts.

5. Exchange-Traded Funds (ETFs)

An international exchange-traded fund offers investors a convenient way to access foreign markets. Picking the right exchange-traded fund (ETF) can be simpler than constructing a portfolio of stocks by yourself.

Some ETFs provide exposure to multiple markets, while others focus on a single country. These funds cover a number of investment categories such as market capitalization, geographical region, investment styles, and sectors.

Prominent ETF providers include iShares by BlackRock, State Street Global Advisors, Vanguard, FlexShares, Charles Schwab, Direxion, First Trust, Guggenheim Investments, Invesco, WisdomTree, and VanEck. Before buying an international ETF, investors should consider costs and fees, liquidity, trading volumes, tax issues, and portfolio holdings.

6. Multinational Corporations (MNCs)

Investors not comfortable with buying foreign stocks directly, and even those who are wary of ADRs or mutual funds, can seek out domestic companies that derive a significant portion of sales from overseas.

Multinational corporations (MNCs) are best suited for this purpose. This could mean buying The Coca-Cola Company (KO) or McDonald's (MCD), both of which generate the majority of revenue from global operations.  This is a back door approach and does not provide true international diversification, though it does give investors international exposure.

The Bottom Line

Knowledge about the political and economic conditions in the country you're investing in is essential to understanding the factors that could impact your returns. As always, investors should focus on their investment objectives, costs, and prospective returns, balancing those factors with their risk tolerance.