Sensible investors put their money to work across the world, rather than only investing it at home.

Buy British or Made in USA are good slogans for the sellers of knitwear, tractors, and cauliflowers, but they’re a poor guide if you want to build a robust portfolio.

This isn’t because I expect the British stock market to whither away like our coal mining or ship building industries did, or because the troubled UK economy is doomed.

On the contrary, I think the London Stock Exchange is one of the world’s most attractive, with companies that offer an appealing mix of growth, income, stability, and innovation.

As for the UK economy, reports of its death are much exaggerated.

Besides, the biggest UK companies that dominate the FTSE All-Share index do over 75% of their business overseas. This means they’re far less dependent on the performance of Blighty PLC than is popularly supposed.

But our companies are more exposed to certain regions of the world than others.

It’s been said, for example, that we export more to Ireland than we do to the BRIC ¹ nations combined, which is a tad worrying given how it sometimes seems there are more Irish backpackers in Irish bars across the world than there are Irish citizens in Ireland!

More generally, UK trade is dominated by business done with mainland Europe.

But trade is a global affair nowadays.

Investing overseas therefore gives you access to different types of companies and opportunities, unconstrained by history or the geographic accident of our lump of rock’s position on the spinning globe.

Gambling with your country’s money

Investing in foreign shares exposes you to currency risk, which is to say your overseas investments will change in value as their price in the local currency fluctuates when converted back into pound sterling.

In the short-term this can be a good or bad thing, in terms of your profit – it depends how exchange rates go after you make your overseas investment.

Over the long-term, however, currency variations on average play a minor role in total equity returns. Currency hedging is expensive and difficult for private investors, so I wouldn’t worry too much about it provided you’ve got a long time horizon and you’re spreading your equity buying across the world.

Oh, and in case you’re wondering if overseas investing means you’ll need to phone city boys in Shanghai or Sydney to place trades, fear not!

While you can hold even individual foreign company shares in an ISA, the majority of us are best off using collective funds for the money we invest away from our home country.

(Most of us are best off in UK trackers, too, for that matter, but that’s a different dozen or so articles).

Investing overseas via funds could entail you buying index trackers that follow foreign markets, like those we use in our Slow & Steady model portfolio. You can even track emerging markets using passive funds.

Alternatively, new country-specific ETFs are debuting all the time, though most investors will find it simpler and safer to aim for broader regional exposure.

Some investors like myself also put money into big global investment trusts like RIT Capital Partners. This trust invests very widely around the world, and its managers actively monitor currency exposure as an added benefit (or not, as it may turn out) for its shareholders.

Investing globally is more helpful with shares than bonds

The main benefit of investing overseas is that diversification across countries can be expected to reduce risk in your portfolio, without doing too much damage to your overall return.

According to the latest research from the very credible London Business School ², the risk reduction you’d have seen from holding the world index rather than owning only domestic equities between 1972 and 2011 made diversification worthwhile for every major country studied except South Africa.

They found that investors in the core 19 countries looked at ³ would have enjoyed a risk reduction of on average 20% from holding the world index, as opposed to if they’d held only their own countries’ shares.

Academically speaking, that’s a trade-off you should take, even if it slightly reduces your return (though see below for more comments on risk).

Investors from Norway and Finland would have seen around a 50% reduction in risk, due to how skewed their economies are, and the overweight presence of a few massively larger companies. Take note, if you’re Norwegian or Finnish!

Interestingly, the professors do not report the same risk-reducing benefits from diversifying into global bonds.

With bonds, the currency risk outweighs the benefits of diversification.

This is probably because in general, a creditworthy government bond is a creditworthy government bond – it pays you a fixed rate of interest and you (hopefully) get your money back when the bond matures.

Hence currency risk looms large with bonds, compared to the minor diversification benefits of holding one developed country’s bond versus another, given that most mature developed world sovereigns have not defaulted in the past few decades. (Some might suggest the professors stand ready to re-write their rule books.)

In contrast to bonds, by buying foreign shares, you are getting access to different country’s industries, trading partners, local specialisms and resources, as well as varied politics and demographics.

That’s real diversification!

The risks of picking the best countries to invest in

Some foreign share markets will likely do a lot better than others in our lifetime, of course.

This means spreading money across the world’s stock markets will likely reduce your returns, compared to if you bought only the best performing markets.

But before you put on your red braces and go winner-spotting, keep in mind:

• Picking winners on the basis of, say, historically faster-growing GDP is a losing strategy.

• Investing in fewer overseas markets will lower the risk-reducing benefits you’ll enjoy, compared to investing in the global index.

• Most people are likely to be as bad at picking winning markets as they are at picking winning stocks, so they will lose to a global tracker (or else they’ll simply pay for any higher returns by taking more risk – see below).

• If a market grows faster or looks cheaper, it may be for a good reason (likely because it will be more risky and/or volatile).

• You’re more likely to stomach the most volatile but potentially highest reward markets – e.g. Brazil or Russia – if their gyrations are offset by steadier holdings elsewhere in your portfolio.

Remember, risk isn’t necessarily something to be entirely shunned. I haven’t got a problem with a young investor putting a bigger allocation into a spread of emerging markets, say, for the prospect of higher long-term returns, provided they’ve understood the extra volatility that’s likely along the way.

But I would still argue against betting very heavily on any particular country, or even region, in the pursuit of extra riches.

Few of us really want to gamble away a happy retirement for the prospect of a few more bottles of champagne in our old age.

Accordingly, most of us should sacrifice a few tenths of a percent of return by spreading our money more widely in order to sleep better at night. It’s the same rationale as that for having a diversified portfolio that includes bonds and other low return, low volatility asset classes.

As we’ll see in my next post, you don’t want to try to pick the United States of the 21st Century, only to discover you actually invested in the equivalent of the Greeks.

1. Brazil, Russia, India and China.[↩]
2. The Credit Suisse Global Investment Returns Yearbook 2012, to be exact.[↩]
3. Basically all the biggies where they have data stretching back to 1900.[↩]

Some great reads from around the Web.

I don’t have to even pause to think what’s going to be my post of the week today – not when star pitcher Warren B. of the Omaha Value Raiders is knocking them out of the park.

In an excerpt from his upcoming shareholders’ letter in Fortune magazine, Buffett pours scorn on today’s mania for cash, and for US, German and UK government bonds with their likely desultory real yields:

Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.

Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as these holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control.

But before you pack your portable stove to join the gold bugs in the hills:

Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct.

Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth — for a while.

So what does hard-to-satisfy Buffett like? Real assets such as shares and productive farmland, of course:

A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops — and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil (XOM) will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons).

[In contrast a] 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.

Pure passive investors will still want to hold and rebalance their chosen portfolio allocations, of course, and not dump all their bonds and any gold they have elected to carry. The idea here is to be smart by acting ‘dumb’…

…rather than being dumb like me by trying to be smart and running down your bond portfolio, only to see gilt yields drop in 2011 to almost unbelievably low levels that we’ve not seen since the 1960s.

I still think gilts are over-priced, however, and that Buffett will prove correct in the medium to long-term. He usually is.

If you were to write a novel about a super-rich investor, you’d surely have him doing all kinds of clandestine activities. Nobody could understand his trades, or how he made it look so simple.

Buffett – who is the world’s richest self-made investor – spends half his time telling anyone who will listen exactly how he does it.

[continue reading…]

This is guest post on spread betting tax avoidance strategies from Andy Richardson of the Financial Spread Betting website.

Before you find yourself packing your bags for an extended stay at Her Majesty’s pleasure, let us remind ourselves that tax avoidance (arranging your affairs so as to pay no more tax than is necessary) is legal whereas tax evasion (failing to pay tax that you actually owe) is definitely illegal.

Some people have argued that tax avoidance is a moral duty. And of course some tax avoidance schemes are state-sponsored – think about National Savings, Individual Savings Accounts (ISAs), and pensions.

If we treat tax avoidance as a legitimate pursuit (and you can make your own mind up about that) then how might spread betting be used as a vehicle for minimising tax liability – specifically avoiding capital gains tax (CGT) liability?

Let’s think about why spread betting is tax-free in the first place.

Why is spread betting tax-free?

The fact that spread betting proceeds are (usually) free from income tax and capital gains tax seems to rest on the fact that for most participants it is classed as gambling rather than investment.

(Editor’s note: How long this will last after the arrival of the potentially more mass-market Halifax Spread Trading service, we’ll have to see!)

With spread betting, you don’t invest in companies by buying shares. You merely make a bet with a bookmaker on whether you think a company’s share price will go up or down. The bookmakers (i.e. the spread betting companies) pay tax on their profits, but you don’t pay tax on your winnings.

So suppose the HMRC did make spread betting proceeds subject to tax. What do you think would happen?

It is said that HMRC would then have to let you offset your spread betting losses against other investment gains, which would be a net loser for the Exchequer because – as we all know – there are substantially more losers than winners in the spread betting game.

But measures can be taken to make spread betting safer.

The logical conclusion of this article is that it may be possible to run a tax-free spread betting portfolio as an alternative to a traditional investment portfolio. But this doesn’t help anyone facing a potential CGT bill due to crystallising a profit in their existing portfolio.

So let’s consider that first, after a quick reminder from Monevator‘s editor.

Wealth warning: While this article explains more sensible ways to spread bet, doing so is still more risky than buying traditional shares with cash – especially if you get your sums wrong! Spread betting on margin can rack up big losses quickly, and you can lose more money than you thought you were risking. This article is aimed at experienced traders and investors. We take no responsibility for your losses in any circumstances.

Hedging a potential capital gains tax liability with a spread bet

One of the features of spread betting is that it is just as easy to take a short position (i.e. bet on a falling price) as it is to take a long position.

This raises the possibility of offsetting an existing position – perhaps in a share you own in the traditional way, or even in a company Sharesave scheme – with a spread bet that neutralises any future fall in price, without you having to trigger a CGT liability by crystallising the profit in your initial portfolio.

Suppose you were lucky enough to ten-bag your shareholding in Penny Stock Corporation (not a real company!) so that your £10,000 investment has become £100,000. With the price so toppy, you want to take your money and run, without having to hand over a proportion of it to Her Majesty’s Revenue and Customs in the form of capital gains tax.

Rather than selling the shares, you might place an equivalent opposing ‘short’ spread bet on the same stock, to the effect that any subsequent fall in your traditional long position is offset exactly by the tax-free rise in the value of your short spread bet.

To help you get your head around this, let’s say Penny Stock Corporation is now priced at 1,000p-per-share (the company is no longer a ‘penny stock’ but at the time you bought it – before it ten-bagged – it was!).

1. A £100-per-point short spread bet should therefore exactly offset your ongoing £100,000 investment.

2. To effectively ‘insure’ the value of your investment in this way, the spread betting company will ask you to deposit a much smaller sum than £100,000 – but obviously you do need some spare cash with which to place the bet.

3. When the tax implications become more favourable, you can close all or part of your traditional long position and the matching short spread bet, so as to release your gains tax-free.

There are some other variations on this ‘hedging‘ theme, like closing a position in your traditional portfolio to fully utilise your annual CGT allowance at the end of the tax year, while at the same time taking out an equivalent long spread bet to ‘keep you in position’ tax-free until such time (after 30 days, according to the HMRC rules) that you can legitimately re-establish your original share holding.

You might even want to crystallise a loss in your traditional portfolio to offset another CGT gain, but to stay ‘in position’ via a spread bet in the same company, just in case the price of the loss-making share recovers.

Spread betting as an alternative to traditional investment

So much for minimising CGT events in your traditional portfolio – do you actually need a traditional portfolio?

There is little that is fundamentally different about holding equity positions in a spread betting account and holding shares in a traditional brokerage account.

• There is no limit to how long you can hold ‘rolling’ equity spread bets.

• You can collect dividends on those positions, albeit at a reduced rate.

• Just like in a traditional share dealing account, when the price of a stock goes up you make money .

• When the price goes down, you lose money.

Which begs the question: why bother with a traditional brokerage account when you could run your ‘investment’ portfolio in a spread betting account, tax-free?

For smaller accounts, this could make perfect sense, because a trader or investor with limited funds can get more bang for his trading buck due to the leveraged nature of spread betting.

You may be able to take a £10,000-equivalent position with a margin deposit of only £2,000, providing you have the balance held elsewhere (in case the spread betting company demands it) or providing you have a very tight risk-management policies using stop orders to limit your potential downside.

For larger account holders, it may not be so easy or advisable to squirrel away a substantial proportion of net worth in a spread betting account.

Still, it could provide a good home for surplus funds beyond the annual ISA and Self-Invested Personal Pension contribution limits, especially if your portfolio that you have sitting outside of these tax shelters seems likely to run up against the capital gains tax-free allowance any time soon.

There are some caveats, of course.

Whereas you pay a one-off dealing fee (plus stamp duty reserve tax) to open a traditional share holding position, a rolling spread bet incurs ongoing financing charges that are levied by the spread betting company in exchange for it ramping up your position size through leverage.

Therefore, your rolling spread bet positions are not so much owned as mortgaged.

For a long spread betting position held overnight, you will normally be charged financing at LIBOR (currently 0.5%) plus 2.5%.

i.e. At (0.5%.+ 2.5%)/365 days, you’d pay 0.008% for each day you held the position.

Of course, in the present low interest rate environment – with many companies trading at what some think are historically low valuations that could multi-bag in short order  – the financing charges could pay for themselves. It’s your call.

(Editor’s note: If you do not want to use leverage, but simply want the tax free benefits of spread betting, you can offset some or all of the financing charges by holding an equivalent cash balance in a high interest savings account. Whether it’s possible to match your costs with interest earned (after tax) will depend on prevailing interest rates at the time. Remember you’ll also need access to ready cash to meet any margins calls).

What about dividends? Well, although you receive dividend-equivalent adjustments on spread bets sooner than on traditional share holdings (i.e. at the ex-dividend date rather than a later payment date) those dividend adjustments are typically 80%-90% of the actual dividend. (For more on this, see the advantages and disadvantages article on my website).

Finally, spread bet positions in individual equities bestow no voting rights or other benefits upon the holders of those positions, unlike share holdings.

Remember: You don’t actually own the shares. You’ve simply made a bet with a bookmaker as to whether they will go up or down in price.

What about index tracking?

Many investors don’t buy individual shares at all, of course. They rely instead on index-tracking funds or exchange traded funds (ETFs) to simply follow the market up and down.

Spread betting may provide a more efficient way of doing this, because I’d argue that a spread bet on a stock index is far more transparent than the tracking errors and Total Expense Ratios (TER) associated with traditional index funds.

If the underlying index rises, your index spread bet position will rise by exactly the same amount, and likewise if it falls. There’s no obfuscated tracking error or TER to worry about –  just the simple bid-ask spread and the ongoing cost of financing your position.

In addition – and perhaps more importantly – tracking overseas markets or shares via spread betting eliminates currency risk. All your positions will be quoted in pounds sterling, as will your profits and losses.

Let’s suppose you’re trading the crude oil contract, which trades in USA dollars.

You opt to buy, staking £1 a point. If oil then rises 400 cents to $104, your profit is 400 times £1 or £400.

If you had bought a USA crude oil futures contract or an ETF, by contrast, your trade and profits would have been in USA dollars. So, if the dollar went down by 5% against the pound during your trade, your profit on oil would have transformed into a loss!

You will find a very wide range of domestic and international indices that you can spread bet, and best of all, the proceeds from this form of index tracking are currently CGT-free!

• Further reading: See my website for other ways to make intelligent spread bets.

Disclaimer: Due to the nature of this article it is important that we include a specific disclaimer. The author of this article is not a tax advisor or investment advisor, therefore you should treat the information given here as for educational purposes only and seek independent professional advice on matters of tax planning and investment.