Investing internationally to diversify your portfolio

What are international stocks?

International investing is an investment strategy that involves selecting investment instruments outside of Canada as part of an investment portfolio. An international stock is equity in a company that trades outside of Canadian stock markets or exchanges. Some examples might include shares in a Brazilian bank trading on the Sao Paulo Stock Exchange, a European aircraft manufacturer trading on the Frankfurt Stock Exchange, or equity in a US-based tech company selling shares on New York's NASDAQ. Stocks that are traded outside of Canada, such as on exchanges in the U.S., Europe, Asia, Africa, or South America, are considered to be international investments. 

Why invest internationally?

As a self-directed investor, one of your top-of-mind questions should always be: Do I have a dynamic and diversified portfolio? Investing in Canadian companies is part of the equation, but there are many economic sectors that simply do not have a large presence in the national market. In Canada, sectors like technology or health care are underrepresented, but they have a strong presence when it comes to generating value on the global market.

"Historically Canadian equities have been overweighted in the financial services, energy, and raw material sectors," points out Sal D’Angelo, CFA, Head of the Portfolio Review Department, for Vanguard in the Americas region. "Other markets like the U.S. are better distributed in areas like information technology, health care, and consumer staples. It is important for investors to 'fill in the gaps' in their portfolio - distributing their risk and benefiting from the potential gains these other sectors can provide." 

While focusing solely on Canadian equities tend to expose investors to the narrower economic and market forces in the national market, international investment offers exposure to a wider array of economic and market driven factors. Historically, statistics show that the volatility of global indexes have typically been lower than indexes built around equities from Canada, or those from any other individual country, including the U.S.¹

As a result, taking advantage of the benefits that international investing can provide is an important consideration for new and experienced investors alike. Some of these benefits include:

• Providing Canadian investors a way to diversify their portfolios by holding assets in other markets.
• Offering them exposure in sectors of the global economy that are underrepresented and not well-distributed or capitalized in Canada.
• Spreading out risk across different sectors since not all sectors of the economy will perform well at the same time.
• Protecting portfolios from major world events because different national economies will not necessarily be affected the same way by wars, natural disasters, climate change, etc.

What are some of the different types of international markets?

The international equity market is separated into two broad categories: developed markets and developing or emerging markets. Developed markets are associated with countries and exchanges that have a long history of equity trading with well-established oversight and governance mechanisms.

Developing or emerging markets have come onto the scene more recently and have equity markets that have a shorter international track record. They are typically linked to national economies that are in the process of rapid growth and development. 

Developed markets

Developed markets include exchanges in the U.S., Europe, and Japan.

U.S. – Given how close Canada is to the U.S., many Canadians have heard of the major U.S. stock exchanges and indexes like the New York Stock Exchange (NYSE) and NASDAQ, or the Dow Jones (DJI) and the S&P 500 Index. Many well-known companies like Apple or Tesla trade their shares on these important stock exchanges.

The U.S. represents close to 45% of the world's $109 trillion equity market². In September 2023 there were over 3100 companies trading on New York's NASDAQ exchange alone³. By comparison, Canada's share of the equity market represents only 2.8% of the global total². The Toronto Stock Exchange (TSE), also the largest in Canada, has listings from just over 1,700 different companies⁴.

Europe - With major trading hubs in Germany, England, and Holland, Europe has some of the other major exchanges in the developed market. The Frankfurt Stock Exchange, London Stock Exchange and the Euronext Stock Exchange in Amsterdam are key centers. Together, the European and UK exchanges made up approximately 14% of the global market in equities in 2023².

Japan - With over 3900 listed companies and a market capitalization of over $5.7 trillion U.S. dollars in 2023, the Tokyo Stock Exchange is one of the top five financial markets in the world⁵.

The pros and cons of investing in developed markets

Pros - In most instances, developed markets offer less risk of sudden political or economic instability. Developed countries also have stronger oversight and stricter controls governing the operation of companies. This results in more reliable accounting and financial reporting – practices that are extremely important in helping ensure the safety and security of any potential investments.

Cons - With increasing debt levels in developed economies, there is a danger that the future may bring slower economic growth or productive future spending could experience a crowding-out effect. Equity market valuations are also well above their historical averages in most developed nations. This could indicate a trend of lower-than-average future returns or make near-term volatility more pronounced if some unexpected event was to occur. 

Developing or emerging markets

Important developing markets include Brazil, India, China, South Africa as well as countries in Latin America, such as Mexico. A characteristic that all these national economies share is that they are in the process of rapid growth and development, but they also have lower per capita incomes, less mature capital markets, and a shorter history of rigorous institutional oversight than markets in the developed countries.

The pros and cons of investing in developing or emerging markets

Pros - The larger and generally younger populations in emerging countries tend to drive higher economic growth rates. They often demonstrate higher consumption levels as well as intensive infrastructure modernization (as in the case of China, in particular), and accelerated integration with the global economy.

Cons - Compared to developed markets, emerging markets are more volatile. Investments in these markets may have a wider range of potential outcomes, and these may be hard to predict. Investors must also be aware that emerging nations may experience greater rates of political and economic instability.

What are the risks of international investing?

International investing, like all forms of financial speculation, carries some level of risk. Some of the common risks include:

• Currency risks – Foreign currencies can depreciate in relation to the Canadian dollar, reducing returns. Over the long term, the exposure to fluctuating foreign exchange rates generates no intrinsic return. Statistically, there is no yield, coupon, or earnings growth generated by exchange rate fluctuations and over time currency exposure typically affects return rate volatility.
• Canadian outperformance – If the Canadian market experiences a bullish period compared to foreign markets, this might represent a significant opportunity cost for an investor with a portfolio weighted towards international holdings.
• Political instability – Economic or political instability can have a knock-on effect that can undermine investor confidence or a company's ability to continue operating. Although country, regional, or currency risk are possible anywhere in the world, these risks are significantly higher in emerging markets where political and economic conditions may be less stable. 

How much should I invest internationally?

A starting point to help investors determine how much to allocate to domestic and international equities, is the global market-capitalization weight. The global market-capitalization weight is an indicator that measures the different types of assets, like stocks and bonds, and their distribution across international markets and asset classes.

Using this model, the distribution of assets and sectors in an individual investment portfolio would mirror global trends in asset allocation and distribution. For example, if in 2023 Canada represented around 3% of the global equity market and the U.S. represented close to 45%, an investor would organize their investment portfolio to match these ratios².

In practice, most of us, particularly those who don't work for hedge funds or major institutional investors, like the idea of investing in our home country. Home bias investing is a phenomenon that is observed in all major developed economies¹. Investors also typically have a number of other considerations such as volatility reduction, the cost of trading, taxes, and government programs that incentivize investing nationally.

According to the International Monetary Fund, Canadian investors were 15 times overweighted in 2022, allocating more than 52% of their stock investments towards domestic equities¹. So, what is an ideal ratio? According to firms like Vanguard Investing, optimal equity asset allocation for a Canadian investor is in the range of 30% towards Canadian and 70% towards international stocks¹.

This strategy not only takes into account the lower market capitalization of Canadian companies but it also opens up investors to key sectors like technology and health care. These are areas that have a huge influence on global market value but far less of a presence in Canada's smaller equity market. 

How can I buy foreign stocks?

Most online brokerage sites like the NBDB trading platform make it easy for Canadian investors to invest in U.S. stocks, providing direct access to the U.S. market. They also offer U.S. dollar accounts so that investors can invest without having to worry about currency conversion at each trade.

However, for those looking to invest outside of North America, things can get more complicated and significantly more expensive. Typically, the brokerage cost and ancillary fees linked with making a purchase on an exchange in Asia or Europe are prohibitive unless you are planning to invest very large sums of money.

This doesn't even begin to consider the dollar costs of multiple currency conversions, and the increased risk involved in following an exchange that operates in a different time zone. Taken together, for the average self-directed investor, the opportunity cost in investing in an exchange outside North America is large.

That is why exchange traded funds (ETFs) and mutual funds are typically the best vehicles to place your money when investing in international markets. For example, the Vanguard FTSE Global All Cap ex Canada Index ETF (VXC) is a fund that tracks the performance of a global equity index focusing on developing and emerging markets outside of Canada. This type of fund is an easy way for Canadian investors to diversify their holdings and get a foothold in sectors of the global economy that are underrepresented in the domestic equities market.

What are ADRs?

ADRs are American Depository Receipts. An ADR is a way for foreign domiciled companies to have their stock listed on a U.S. exchange. It is a receipt that is issued by a U.S. bank that allows an investor to purchase a foreign security without having to buy it on an overseas exchange.

Though ADRs can save investors some of the fees involved, they are usually reserved for highly capitalized, blue-chip companies. Moreover, not all firms choose to offer ADRs.

Explore the features of our ETF Centre 

Can I just buy stock in a Canadian multinational company?

A common question is whether domestic multinational companies have enough coverage of foreign markets embedded in their stock value. The logic is based on the idea that since many large domestic firms generate a significant portion of their revenue from foreign operations, the diversification benefits of global investing are reflected in their price and performance.

While this may be true to some degree, professional investors believe that holding international investments directly or through ETFs remains a better option because :

• Focusing on domestic companies means that the investor has no stake in leading global companies that are outside their home market.
• Many domestic multinationals will try to hedge away the currency fluctuations of their foreign operations. This may smooth revenue streams, but it also eliminates the benefits that foreign exchange can play in diversifying an investor's portfolio when currency rates are favorable.
• A portfolio made up of domestic firms, including domestic multinational firms, is less likely to have diversified sector exposure than a well-rounded global equity market portfolio or an ETF built on global equity market exposure.

International investing is an important part of ensuring that self-directed investors have a balanced and diversified portfolio. In addition to investing in Canadian equities, international markets offer investors exposure to sectors of the global economy that simply do not have a large presence in the Canadian market. Don't forget that investing always involves some level of risk. Do your research, invest thoughtfully, and help grow your portfolio!