Why investors should venture overseas

Investing in emerging markets can be risky. But avoiding them altogether is a mistake, says Tim Bennett. Here he explains why - and how to avoid getting burned.

Even the best investors can get burned in foreign markets. Fidelity's Anthony Bolton launched his China Special Situations investment trust to great fanfare two years ago. Yet it is down around 25% since then, underperforming the wider market.

This dire performance comes from a man who turned in a near-20% annual return for 28 years at the helm of his Fidelity UK fund. So you might ask, what hope is there for the rest of us?

But avoiding investing overseas would be a mistake. As Jerome Booth of Ashmore Group notes in Forbes, "50% of economic activity on the planet is in emerging markets". So while we're not desperately keen on emerging markets as a whole at this point in time, writing them off altogether is a mistake.

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With Japan's market recently hitting a 28-year low, for example, there are often huge value opportunities overseas in more mature markets that you can't get by sticking to Britain. So what's the best way to invest in more exotic markets without running into trouble?

Investors, especially novices, face at least three challenges when buying individual shares in foreign firms directly. There's currency risk the danger that what you make on a stock will be lost in exchange-rate movements. Secondly, there's the access problem not all countries are open to overseas investors (or certainly not private ones). Thirdly particularly in emerging markets there's the question of whether or not you can trust the numbers. Many foreign markets don't offer the same level of accounting or regulatory safeguards as the American or British markets. So what are the alternatives?

You could buy Western firms who sell overseas. BMW now sells more cars in China than in America, for example. The trouble is, these sorts of stocks are rarely pure plays on a single market you may end up with as much exposure to soggy Western economies as to faster-growing ones. On top of that, the luxury goods firms that have benefited most from this overseas exposure now look very vulnerable to any slowdown in China.

Alternatively, you can buy a fund. This at least gives you exposure to a wide range of stocks and puts the onus on the fund manager to do the hard work. There are some quality investment trusts out there with sound track records, such as Aberdeen Asian Smaller Companies (LSE: AAS), and First State's Scottish Oriental Smaller Companies (LSE: SST).

However, as Bolton's foray into China shows, fund managers don't always deliver and you still have to pay up for their stock-picking skills, even if they don't. A cheaper alternative is exchange-traded funds (ETFs).

They offer an easy way to access almost any market you want, from a specific country (such as Japan), to a region (Asia), or even a theme (BRICs). They simply track an underlying market, so charges tend to be lower than for managed funds.

However, there are still some caveats. Do check the top holdings and geographic exposure via the fund factsheet. Overseas stockmarket indices are often dominated by just a few stocks or sectors, so in buying the wrong ETF you can end up with almost as much concentrated risk as if you'd bought just one stock which rather defeats the point.

Don't snatch defeat from the jaws of victory

As we note above, ETFs are a cheap and simple way to get long-term exposure to your favourite markets. The Psyfitec blog notes: "fundamentally, the beauty of an index tracker is that it largely removes the psychological problems associated with choosing and timing the buying and selling of shares". That in turn saves us money on average investors lose up to 6% a year on overtrading, due to indecision about whether or not they should be in a stock. This is great news for brokers, but no one else.

Given the increasing popularity of ETFs, you'd think that investor performance would be improving. Not so, apparently. Researchers at Goethe and Indiana Universities focused on trading activity at one of the largest brokerages in Germany. They found to their surprise that the use of index trackers was not having the expected beneficial impact on portfolio performance.

Why not? Because investors were using these passive funds as a way to trade in and out of themes such as buying small caps versus large caps, or trading in and out of geographic sectors. Having supposedly abandoned the trap of jumping in and out of stocks, by moving to ETFs, it seems investors can't resist the urge to fund-pick instead. Having identified the main benefit of ETFs cost "people manage to snatch defeat from the jaws of certain victory".

The message is simple: once you've identified the right long-term fund for you, stick with it. The fact that you can trade in and out of an entire sector or market using an ETF doesn't mean you should.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.