Investing Overseas Is Riskier Than You Think

In an era of huge growth in exchange-traded funds, investors are used to being able to buy and sell stocks and funds pretty much whenever they want. But with overseas stock markets making wild moves, the investments you use to access those markets aren't always open for trading when they are -- and sometimes they end up moving a lot differently from how you might think they should.

Dealing with investing jet lag
For U.S. investors, ETFs that trade in U.S. stocks and bonds typically work just about exactly how you'd expect them to. If the Dow falls 1% in a given session, then you can expect the ETF that tracks the Dow to fall by roughly that same 1%. If it didn't, then the resulting tracking error would have most investors looking for a new ETF.

But with ETFs that track foreign markets, things aren't nearly as cut and dried. Often, you'll see big disparities between how overseas stocks fare and how ETFs that track those stocks perform on a given day. Take a look at these recent examples:

  • Yesterday, European stocks took a huge fall on fears about Italy's soaring bond yields. Yet while the German DAX index fell just over 2%, the iShares MSCI Germany ETF (NYS: EWG) fell much more steeply, losing more than 7%.

  • Similarly, the Brazilian Bovespa index was down around 2.5% yesterday. But iShares MSCI Brazil (NYS: EWZ) dropped more than twice as much.

  • Conversely, sometimes ETFs outperform local markets. On one day earlier this month, the Japanese Nikkei index dropped more than 2%, but the iShares MSCI Japan ETF (NYS: EWJ) actually rose slightly. Market Vectors Russia (NYS: RSX) and iShares FTSE China (NYS: FXI) also saw outperformance versus its home market index.

These discrepancies may raise warning flags in your mind as to whether an ETF is actually doing its job. But there's a simple explanation that you have to understand in order to avoid confusion when you invest in foreign stocks.

Playing leapfrog
The problem that ETFs focused on overseas markets have is that ETFs are typically open for trading at vastly different times from when their target markets are open. So if some important news even happens in another country overnight, U.S. investors obviously won't see the impact on their ETF shares until the U.S. market opens. And more importantly, if news hits when those overseas markets are closed, ETF shares should reflect the anticipated impact of that news on those markets when they open the following day. With all the international turmoil that's been going back and forth lately, investors have had plenty of opportunities to see this phenomenon in action over the past several months.

In addition, remember that most foreign markets are denominated in their local currency. Because ETF shares trade in U.S. dollars, a big move in exchange rates can lead to major disparities as well. For instance, yesterday, the euro lost nearly $0.03 in value due to Italy's concerns. That compounded losses in dollar terms, creating much of the difference noted above.

What you can do
If you want to invest abroad but avoid some of those complicating factors, there are steps you can take. One is to stick with foreign securities that are dollar-denominated. For instance, iShares JPMorgan USD Emerging Markets Bond (NYS: EMB) invests in fixed-income securities from emerging-market countries. But unlike WisdomTree Emerging Markets Local Debt (NYS: ELD) , which chooses securities denominated in local currencies, the iShares ETF sticks with dollar-based securities that are sheltered from currency impacts.

In general, investors who look to invest abroad actually want the benefit of currency diversification, so these risks are actually benefits. But to the casual investor, such disparities in returns may be shocking. Be sure you know how your ETF works before you invest; that way, you shouldn't get any unpleasant surprises.

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At the time thisarticle was published Fool contributor Dan Caplinger tries to take smart risks. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy works the whole world 'round.

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