Costs and Taxes

Concern

The cost of investing internationally is significantly higher than investing domestically because of many factors. First, gathering information about foreign stocks is more expensive. Foreign companies reveal much less information about their operations than their American counterparts because they do not have the same kind of disclosure requirements. Moreover, the information that is available in the public domain is more difficult to obtain and more expensive. Investors must subscribe to foreign database subscription services, fax services, and foreign newspapers and pay for expedited delivery to obtain the information in a timely manner. And differences in accounting practices mean that financial statements are not easily comparable. These difficulties make research required to value foreign company more expensive and more uncertain.

The second cost factor relates to the cost of trading. Trading costs consist of exchange commissions, brokerage commissions, transaction taxes, and market impact costs. Exchange costs must be incurred for converting dollars into another currency. Depending on the currency, these costs range between 0.05 percent and 0.1 percent for the more actively traded currencies and up to 0.25 percent for other currencies. In addition, foreign brokers charge higher commissions than U.S. brokers. Compared to a fee of 0.1 percent for large transactions in the United States, foreign brokerage commissions can run from 0.1 percent to more than 1.0 percent in other countries, including developed markets. Almost all governments impose taxes on stock trades. In the United States there is an SEC fee that is currently 0.00301 percent on all stock sales. Other governments may and do charge much higher fees, as much as 0.5 percent of the sale amount. Some countries charge fees on both buys and sells. Besides the fees and commissions, there is a market impact cost that must be borne by the investor. Whenever large trades are made, there is an impact on the price. If a large buy order is placed, the price increases to induce more market participants to part with their stock. Similarly, when a large sell order is placed, the price falls so that the stock becomes attractive to reluctant buyers. This impact on price occurs in all markets. However, the price impact of a trade is likely to be larger in foreign markets because they tend to be smaller and less liquid than U.S. markets. The high trading costs reduce the returns available from international investing.

Another form of tax is the withholding tax on dividends. This tax is usually about 15 percent and withheld by the foreign government. The investor must claim a set-off against other taxes. The withholding tax creates two problems. First, the extra hassle of paying taxes and then reclaiming those taxes with a time lag is a cost incurred by investors in foreign securities. Second, tax-exempt investors such as pension plans completely lose the withholding tax because they are not liable for payment of any income taxes.

All of the above costs due to information, trading, and taxes were ignored in prior analyses. The firm of Elkins and McSherry reports that costs directly related to trading vary considerably among the forty-five emerging and developed markets. It finds the highest trading costs among emerging countries for Venezuela (2 percent), highest among developed markets for Ireland (0.90 percent), and the lowest among developed markets for Japan at 0.22 percent. The trading costs in American and German markets are about 0.29 percent.

Rejoinder

Information costs, trading costs, and taxes can indeed reduce the net return earned from foreign investments. However, the costs are still smaller than the gains from international investing. In addition, for most individual investors, American depository receipts (ADRs, discussed below) provide an easy and inexpensive way to trade where the costs of trading foreign stocks are equivalent to those for trading domestic stocks.

Currency Risk

Concern

Holding foreign securities denominated in foreign currencies entails currency risk, as dollars must first be converted into foreign currencies and the foreign currencies converted back into dollars at the future rate. As the future rate is unknown, investing in foreign markets suffers from an additional risk due to currency fluctuations.

Rejoinder

Yes, there is currency risk due to currency conversions and uncertainty with regard to future exchange rates. However, as all of the returns reported in the earlier tables are in dollar terms, those returns already incorporate associated currency risk. Thus currency risk is important in foreign investments but has already been accounted for. Currency risk can also be hedged if desired (see “Currency Hedging”).

Political and Economic Risk

Concern

Investors are also concerned about big changes in the economic conditions due to a change in the political orientation of the government. While this is of most concern in emerging markets, even the developed markets are not immune to a dramatic change in the environment. Obviously, large changes are risky for equity markets. In addition, foreign investors are also concerned about currency regulations that may hinder repatriation of capital/income. For example, Malaysia did not permit repatriation of capital for one year following the 1997 East Asian currency crisis. Other countries routinely make it difficult for investors to transfer funds out of the host country

Rejoinder

This is a valid concern. However, there are numerous stock markets. It is easy to exclude countries that have an unstable political history or have restricted capital flows in the last decade. An investor can pick many developed markets and emerging markets where the political risk is relatively low. See “Internet References” for websites providing this information.

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