In our last column we reviewed where Canada fits in among the world’s largest exchanges. Many investors have a “home country bias” that prevents them from looking at the many foreign investment opportunities because it is perceived as too risky. It’s true that investments outside our border involve additional risks not present in Canadian securities, but we feel the risk of having no foreign exposure is greater. Let’s look at some of the potential dangers.
One of the main risks to foreign investments is currency fluctuations. Another factor that is critical when looking at foreign investments is the impact on changes in exchange rates compared with the Canadian Dollar. Using the U.S. dollar as an example, the loonie ended the year with a $1 US to $1.16 CDN exchange rate. Some economists have a one-year forecast of $1 US to $1.11 CDN. This would result in a Canadian dollar appreciation of 4.7 per cent. If this forecast is correct, and all else being equal, investors would be better off having Canadian dollar denominated investments. It is quite possible for individuals with U.S. securities to have sold a position for a higher share price but incur a loss after the currency conversion. As Canadians we pay our bills in Canadian dollars and we need to consider currencies when determining real returns.
Foreign governments cay interfere with the operations of local corporations. The stability of the government is certainly important for investors to get comfort on policy changes. Investors also want to know that if things go off track, will the rule of law prevail? China is the perfect country to discuss political risk. Investors should not ignore the fact that this one-party state is going through significant reforms. The rules under which China operates today could change with little legal recourse. Canada witnessed evidence of political influence on the investment climate in 2005 with the elimination of the foreign content rules for registered accounts, announcements regarding income trusts and the proposed changes on the tax treatment of dividend income.
Many companies may seek out those countries with relatively weak regulations. Countries without labour standards may have a competitive advantage over other countries that have stricter regulations. The lack of environmental guidelines may increase profits but at what cost? Environmental catastrophes can severely damage or bankrupt a corporation. India is a good country to look at regarding regulatory risk. Many corporations in both Canada and the United States have outsourced much of its operations to lower cost regions such as India. Governments around the world change the regulation on certain industries and intervene in ways that affect the normal flow of the markets.
The term liquidity refers to the availability of an investor to access or convert the investment into cash. Many foreign investments have restrictions that limit the amount of trading or the frequency with which an investor may request redemption. A market is considered liquid if an investor can convert the investment easily into cash. Trading volume and bid-ask spreads are key indicators of liquidity.
Investors were outraged with the shortfalls that have been identified with the failures of corporate giants such as Enron or WorldCom. These failures occurred in a country with established accounting and auditing standards and a strong regulatory body. There are economies around the world that do not have established accounting and auditing standards. Others are quickly scrambling to catch up. It is near impossible to assess the merits of an investment without true and accurate financial statements. If financial statements exist they may be in a foreign language unknown to the investor and the standards may be different from domestic requirements.
In our next column we will discuss the numerous ways that Canadian investors can add foreign exposure to their portfolio. It is important when adding foreign investments that it is consistent with your overall portfolio strategy. If you do not have a strategy that takes into account foreign investments we recommend that you discuss this further with your investment advisor.