What Are International Funds?
International funds are a type of investment vehicle, typically mutual funds or exchange-traded funds (ETFs), that primarily invest in securities issued by companies or governments outside of an investor's home country. These funds fall under the broader financial category of portfolio management and are designed to offer investors exposure to foreign markets. By focusing exclusively on non-domestic assets, international funds aim to provide geographical diversification, potentially reducing overall portfolio risk by spreading investments across different economies and regulatory environments. Investors use international funds to tap into growth opportunities in regions like emerging markets or to gain exposure to established companies in developed markets outside their own borders.
History and Origin
The concept of investing across borders is as old as trade itself, but the widespread availability of specialized international funds for individual investors is a more recent phenomenon, largely emerging in the latter half of the 20th century. As global economies became more interconnected and capital markets matured, the demand for easier access to foreign investments grew. The liberalization of capital flows and advancements in communication technology facilitated this expansion. The International Monetary Fund (IMF) has documented the significant increase in global financial integration and cross-border capital flows, particularly from the 1980s onwards, which paved the way for the proliferation of international funds as accessible investment tools.6 This period saw a shift from largely domestic investment portfolios to those actively seeking opportunities and diversification benefits beyond national boundaries.
Key Takeaways
- International funds invest exclusively in securities outside of an investor's home country.
- They provide geographical diversification, potentially enhancing returns and reducing market volatility.
- These funds are subject to unique risks, including foreign exchange risk and political risk.
- They can be structured as actively managed or passively managed vehicles.
- International funds offer a convenient way for individual investors to gain exposure to global economies.
Interpreting International Funds
Interpreting international funds involves understanding their specific investment objective and how their performance relates to global economic conditions. When evaluating international funds, investors often look at their exposure to different countries and regions, the types of securities held (e.g., equities, bonds), and the fund's approach to managing risks inherent in foreign markets. For instance, a fund heavily invested in emerging markets may offer higher growth potential but also carry greater risk than one focused on stable, developed markets. Analyzing the impact of currency fluctuations on a fund's returns is also crucial, as exchange rate movements can significantly affect the value of foreign assets when converted back to the investor's home currency.
Hypothetical Example
Consider an investor, Sarah, based in the United States, who wishes to diversify her portfolio beyond domestic equities. She decides to invest in an international fund that focuses on European and Asian companies. Sarah invests $10,000 into the "Global Opportunities International Fund."
Suppose the fund's holdings include shares in a German automotive company and a Japanese electronics manufacturer. Over a year, the German company's stock rises by 10% in euros, and the Japanese company's stock rises by 8% in yen. However, during the same period, the euro depreciates by 2% against the U.S. dollar, while the Japanese yen appreciates by 3% against the U.S. dollar.
When calculating her return in U.S. dollars, the euro's depreciation would slightly reduce the positive impact of the German stock's gain, while the yen's appreciation would enhance the Japanese stock's gain. This example illustrates how the performance of an international fund is not solely dependent on the underlying asset's performance in its local currency but is also significantly influenced by foreign exchange risk. Despite the added complexity, Sarah's goal of diversification is met by gaining exposure to non-U.S. economies.
Practical Applications
International funds are widely used by investors seeking to implement asset allocation strategies that include non-domestic exposure. They are a common component in portfolio construction for both individual and institutional investors. These funds allow for convenient access to a broad range of foreign securities without the complexities of direct foreign stock ownership, such as dealing with multiple foreign exchanges or local regulations. The U.S. Securities and Exchange Commission (SEC) highlights that U.S.-registered mutual funds and exchange-traded funds investing abroad can help reduce some of the risks associated with international investing because they may offer more diversification than an individual investor could achieve on their own and are subject to U.S. regulations protecting investors.5 Furthermore, they are often employed by advisors assisting clients in achieving geographical diversification and tapping into potential growth in economies outside their home country.
Limitations and Criticisms
While offering significant benefits, international funds come with limitations and criticisms. One primary concern is the exposure to various non-market risks, including foreign exchange risk, political risk, and differences in accounting standards and regulatory environments across countries.4 Transaction costs can also be higher for international investments compared to domestic ones, due to factors like higher brokerage commissions, local taxes, and currency conversion costs.3
A notable phenomenon in international investing is "home bias," where investors tend to disproportionately invest in domestic assets relative to what global portfolio theory might suggest. This tendency persists despite the theoretical benefits of international diversification. Academic research has explored various explanations for home bias, including information asymmetry, transaction costs, and behavioral factors such as familiarity preference and optimism towards domestic firms.1, 2 This phenomenon suggests that even with the availability of international funds, investors may not always fully capitalize on global diversification opportunities.
International Funds vs. Global Funds
The terms "international funds" and "global funds" are often confused, but they have a distinct difference in their investment scope.
- International Funds: These funds invest exclusively in securities issued by companies or governments outside of the fund's home country. For a U.S.-based international fund, this means it would invest in European, Asian, or Latin American stocks and bonds, but no U.S. securities.
- Global Funds: These funds have a broader mandate, investing in securities worldwide, which includes both the fund's home country and foreign markets. A U.S.-based global fund, for example, could hold a mix of U.S., European, and Asian equities.
The key distinction lies in the inclusion or exclusion of domestic assets. International funds offer pure foreign exposure, while global funds provide diversified exposure across both domestic and international markets, aligning with a more comprehensive "active management" or "passive management" approach to worldwide markets.
FAQs
Why invest in international funds?
Investing in international funds offers potential benefits such as diversification across different economies, industries, and political systems, which can help reduce overall portfolio risk. It also provides access to growth opportunities in countries and regions that may be performing better than the investor's home market.
What are the main risks of international funds?
The main risks include foreign exchange risk (due to currency fluctuations), political risk (instability in foreign governments), economic risk (recessions or crises in foreign economies), and liquidity risk (difficulty selling assets in less developed markets). Additionally, differences in regulatory environments and accounting standards can add complexity.
Are international funds suitable for all investors?
International funds can be suitable for investors looking to diversify their portfolios and potentially enhance returns. However, due to the added risks, they might be more appropriate for investors with a moderate to high risk tolerance and a long-term investment objective. A thorough understanding of the risks involved is essential.
How do I choose an international fund?
When choosing an international fund, consider factors such as the fund's investment strategy (e.g., focus on emerging markets or developed markets), its expense ratio, past performance (though not indicative of future results), the fund manager's experience, and how it aligns with your overall asset allocation and risk tolerance.