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Diversification, Diversification, Diversification
Diversification as a concept is so important, that it merits a mention every time we talk about investments.
Diversification of your portfolio means mixing a wide variety of investments to make sure that you’re not overly reliant on one particular type of asset class.
Over the long term, diversification offers the benefit of maximising your returns while minimising risk.
Typically when someone thinks of diversification, they think of buying multiple asset classes such as bonds, gold, real estate etc. to average out the risks associated with only buying shares & equities.
However, a key aspect of diversification that is also quite important for Aussies to consider is geographic diversification. Here’s why:
- The total market capitalisation of the Australian Securities Exchange (ASX) is approximately 2% of the total global market capitalisation.
- ASX has a huge dependence on Financials and Materials which contribute to almost 50% of the total market capitalisation of ASX200, whereas sectors like Technology and Healthcare are just a tiny sliver in that pie.
What this means is that when you invest only in the Aussie share market, you’re limiting yourself to less than 2% of the global opportunities, with only two sectors taking centre stage, making your investments extremely susceptible to a sector-specific downturn.
The Banking Royal Commission is a good example of how a sector-specific issue in the Financials dragged the ASX 200 down by almost 13% from Dec 2017 when it was announced to June 2018. In a more diversified exchange, perhaps, the impact on the overall index would not have been so pronounced.
In this chapter, we will dive deeper into diversification and what you'll need to know about international investing, specifically:
- Exposure to International equities is the antidote
- How to start investing in International markets
- Nuances of Investing Internationally
- Where and how much you should invest in International shares
- The verdict
Exposure to International equities is the antidote
Investing in the global share markets can help provide the much-needed diversification for Australians not only across different international markets but also across multiple sectors and blue-chip companies.
Access to Global Markets
Each country’s economy has a country-risk associated with it. The more developed an economy, the lower the country risk. But with a lower risk also come lower returns. Investing in international equities lets you participate in the growth of other countries and geographies, therefore optimising your returns, while also keeping the risk fairly contained.
While historically, the Australian economy has grown robustly, it is expected that its growth rate along with that of other developed economies such as the US will slow down while that of the Emerging Economies will gain momentum. When looking at investments from the angle of FI, it is important to look at long-term growth. Therefore investing in different economies, which are at different stages of their economic life-cycle, will make sure that you’re not overly exposed to the blips in the growth of one particular economy and your bets are sufficiently hedged.
The chart below compares the performance of the top Aussie shares (ASX 200) with that of the top US shares (S&P 500) over a 10 year period. If you had had some portion of your investment in US shares you would have been able to get great returns from that amazing growth.
Sector Diversification
The Australian share market has a disproportionately large dependence on the Large Four banks and Materials companies such as BHP & Rio Tinto. When investing internationally, it is possible to branch out and to get exposure to other core & growth sectors such as Technology, Healthcare and Consumer Discretionary. This helps reduce the concentration risk of the portfolio, spreading it over multiple sectors in different geographies while also stabilising returns. So if a particular sector in a certain geography is facing difficulties, the others in your portfolio will ensure that your overall returns stay relatively insulated from these aberrations.
Blue-Chip Stocks
The ability to invest in global markets also gives you the ability to buy stocks of global blue-chip companies such as Apple, Amazon, Microsoft, Johnson & Johnson, Coca Cola, Samsung etc., in case you follow the investment strategy of stock-picking. For a lot of people, buying shares of the top global companies provides a lot of peace of mind because of the stable growth prospects and the quality and depth of these companies.
How to start investing in International markets?
Your approach to investing in international shares will depend on your overall investment approach. There are three main ways in which you could invest in global equities.
- Directly buying international shares - In case you are following the investment approach for stock-picking, this is perhaps the methodology that would appeal to you most. You can pick and choose the international stocks that you want to buy directly from the exchange where they are traded. Not all stockbrokers allow trading of international shares, so that is a factor you would have to consider when choosing a stockbroker. More on this later.
- Through a Managed Fund - Managed funds are pooled funds which are managed by an investment professional. Many managed funds which invest in international markets trade on the ASX and therefore do not require you to actually invest in the international exchanges. These funds, however, come with high management fees especially for international themed funds because the amount of pooled funds are generally more limited.
- Through Exchange Traded Funds (ETFs) - Just like Managed Funds, there are many international-themed ETFs that trade on the ASX. But because these typically track global indices not necessitating the stock-picking expertise of fund managers, their management fees are much lower. You can also buy ETFs traded on global indices, however, most funds such as Vanguard, BlackRock, iShares, etc. have introduced so many ETFs on the ASX targeting different investing themes and geographies that buying ETFs on other exchanges has become superfluous. Do note that it is possible for an ETF to be listed in ASX but to be domiciled outside Australia. From a taxation and DRP perspective, these ETFs are the same as internationally listed shares and come with the same complexities. Currency risk, however, is limited to Dividends and does not impact capital growth because they are listed and traded on the ASX in AUD terms.
Nuances of investing internationally
While investing internationally isn't much different from investing in Australia, there are some key differences that are worth knowing about and considering.
Stockbroker support and fees for international trading
Not all stockbrokers will allow you to trade international shares. So, if you want the ability to be able to buy stocks and ETFs on international exchanges, you should make sure that your stockbroker supports such transactions. Also of note is the fact that there would be fees other than the typical brokerage that would be levied on these transactions.
- Custody Fees - Unlike the Australian CHESS system, you will not own your international shares directly. Your shares will be held by a custodian on your behalf who may charge you a fee for their services.
- FX Spreads - Because your Aussie Dollars will have to be converted to the local currency of the Exchange you want to transact in, Forex related charges and conversion fees that would have to be borne.
- Exchange Related Fees - Some global exchanges charge transaction fees for buying and selling on them.
Currency Risk
Investing internationally comes embroiled in the Forex quagmire. Global currencies are ever fluctuating. When you invest in international shares, the relative movement between the AUD and that particular currency could have a huge impact on your overall returns.
This is because along with the share market risk that you typically take when investing in an ASX listed share, you will also be simultaneously taking the forex risk when investing internationally.
So if you buy a share in the US which provides a return of 2% in the first year in USD terms, but if the AUD has depreciated by 2% against the USD in the same period, your effective return in AUD terms will be zero. If the AUD had however appreciated, then your overall AUD returns would be higher than what the stock actually gave. This means that your returns can fluctuate very wildly.
If you do not want to bear the currency risk, then there are many ASX listed Managed Funds and ETFs that can provide you with hedged returns.
A special mention should be made of ASX listed but foreign domiciled ETFs here. While these ETFs trade on the ASX and have unit prices denominated in AUD, the dividends that they provide are in the local currency of their domicile, so will be exposed to a forex risk, whereas the capital gains will not be.
Dividend Reinvestment Plans (DRPs)
Aussies cannot opt-in for DRPs for international shares and ETFs. This also applies to international ETFs that are listed on the ASX but are not domiciled in Australia. So you would have to re-invest any dividends back manually once you’ve received them.
Taxation
Just dealing with taxation within one jurisdiction is complex enough but when you add more to the mix it becomes even more so. There are a few important aspects related to taxation that you should be aware of before you start investing in international shares. Your international taxation details will not be automatically populated in your ATO tax return form, you will need to manually provide the details.
Dividend Franking
Franking credits are a tax rebate that is available on dividends received from companies that have already paid company tax. This is a uniquely Australian concept and we covered this in more detail in Chapter 13.
Any dividend that you receive from your international investments will not have any franking credits associated with it. So if you receive a $100 dividend from your Aussie investments which have a franked component of $70, you would only have to pay taxes on the unfranked component of $30. Whereas, if you received the same $100 dividend from your international investments, you would be required to pay taxes on all of it, which would make your post-tax returns from your Australian investments much more superior. But remember, that dividends are only one part of the returns. The other, and in most cases a bigger chunk, comes from capital gains. So you should look at them combined to determine which one, your Aussie or international investments, offer you better returns.
Withholding Taxes
Any dividends that you earn from your international investments will be subject to a Withholding Tax, which is typically around 30%. To avoid double taxation of this dividend income, Australia has Double Taxation Avoidance Treaties (DTAT) with almost all the major countries in the world. Double taxation occurs when the dividend is taxed in the foreign country where it is generated and then again in Australia. Under the DTAT, when you file your tax returns, you will be able to get tax credits for any taxes that have already been withheld by the foreign country. You will, however, be responsible for informing the country that you are investing in that you are an Australian tax resident so that they can take their DTAT with Australia into account when they levy a Withholding Tax. This information is typically provided by filling country-specific forms such as the W-8BEN form when buying shares in the US. Do note that you won’t be able to avoid tax leakage in case you invest in a country that Australia doesn’t have DTAT with.
Capital Gain Taxes
Any capital gains from your international investments will be taxed in Australia just like your Australian investments.
| Investing in Australia Shares | Investing in International Shares | |
|---|---|---|
| Stock Broker Support | Available (Of course!) | Limited |
| Transaction Fees | Single transaction fee | Multiple types of fees |
| Currency Risk | NA | Medium to High |
| Dividend Reinvestment Plans | Yes | No |
| Taxation | Simpler with Franking Credits | Complex with no Franking Credits |
Where and how much should you invest in international shares?
The answer to both these questions will depend on your risk appetite.
When investing internationally, it is quite typical for Aussie investors to invest in US shares. The US is the largest economy in the world and contributes to more than 50% of the global market capitalisation. However, in the medium to long term, it is expected that the growth of the developed economies will taper off and that China will take over the US as the largest global economy. Keeping that in mind and acknowledging that the Emerging Economies such as China, India, Brazil, South Africa, etc. have been growing much faster than the developed world, it also makes sense to get some exposure to these.
The contribution of international shares can range from 30% - 55% of the total growth assets in your portfolio. It can be on the lower end of the range if one is more risk-averse. Our portfolio has about 60% invested in international shares.
The proportion between US/ Developed Market shares vs Emerging Market shares is also a factor of risk appetite and overall goal. Of our international exposure, we are currently 50% invested in US equities and 50% invested in emerging markets.
The verdict
Investing in international shares can seem complex, but there are a lot of ways available in the Aussie market to get international exposure, without dealing with any of the hassles. Irrespective of how you get international exposure, it’s important that you get some. It’ll only make your overall portfolio stronger.
About Ms. FieryIce from Two To FIRE | twotofire.com
Ms. FieryIce is one half of Two To FIRE, a Sydney-based couple of 30-somethings. Despite our background in finance and analytics, we were clueless about FIRE until 2019. Having realised the power of its principles, we have started our journey towards Financial Independence. We write about our experiments with investing and personal finance at www.twotofire.com.
NOTE: Aussie FIRE is a free educational resource prepared by Pearler, with permission from the co-authors. At Pearler, we strive to make investing for your long term goals easier and fun, but we only provide general information and/or general advice. We don’t present you any options based on your personal objectives, circumstances, or financial needs. Any advice is of a general nature only. All investments carry risk. Before making any investment decision, please consider if it’s right for you and seek appropriate taxation and legal advice. Please view our Financial Services Guide before deciding to use or invest on Pearler.
