What Works: Reader Questions on Overseas Investing

How liquid are international ETFs, and just how much do you have to put up to buy foreign ordinaries? These are some questions that readers asked in response to my series on online sites and services for international investing. Today I answer some of those questions.

Minimum Investment

David DeKok of Harrisburg, Pa., asks about the minimum investment requirements for trading certain foreign ordinaries (shares issued on local foreign exchanges): "This has always been a frustration for me," he says, explaining that he's tried to buy European and Indian stocks through Charles Schwab. "You never know which ones, until you call and try to buy, [and find out that it] requires a purchase of at least $10,000 worth. ... No one has ever been able to explain to me why some [ordinaries] bear this requirement and others don't, or how to determine which is which without a call."

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It's a simple question with no simple answer. Essentially, there are two reasons why you'll encounter minimums. First, with some foreign ordinaries, such as many Japanese stocks, there is a "lot" requirement. That is, you have to buy at least, say, 100 shares or 1000 shares. Second, when shares are purchased through a foreign local broker, there are certain charges that go along with that transaction -- like clearing and custodial charges (assessed by the local bank holding the shares) -- that make it potentially unprofitable for the local broker to do the trade for less than a certain amount.

Unfortunately, these factors do not translate into clean rules. Each U.S. broker has a different policy, which depends in part on its relationships with local overseas brokers.

Schwab's rule of thumb on purchases conducted through a local broker (in contrast to situations where a U.S. market maker has shares in its inventory -- see this column for more on this subject) is a $10,000 minimum purchase. Fidelity sets a $5,000 minimum if it can't find a U.S. market maker with shares of the stock in inventory. Online firm Globeshare, which doesn't work with market makers but has local broker relationships, advises its clients against doing trades under $5,000 because of the costs involved -- though it doesn't prohibit them. Intltrader.com, which brokers shares from its sister company, a U.S. market maker in foreign securities, doesn't set any dollar minimums. (All firms have to pass along exchange-imposed lot minimums.) (See this related column about the service at these four firms.)

ETF Volume

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In response to my positive review of international exchange-traded funds (ETFs) known as iShares, reader David Fry urged me to "consider the very real dangers individual investors face with the potential lack of liquidity in iShares. Given that daily volume statistics reflect scant trading activity in these international derivatives, individuals might unknowingly overpay, or under-receive, for these thinly traded securities."

Fry raises an important question that I'd like to spend some time discussing: whether retail ETF investors can end up with a price that's not in line with the underlying value of the portfolio because of low volume. There are good reasons why this should not be a major concern for investors, which I discuss below. Unfortunately, though, there aren't hard numbers to back up much of the iShares' defenses, particularly for international ETFs. And neither the Amex nor Barclays Web sites do a good job of explaining the issues. (Most international iShares trade on the Amex, and they are products of Barclays Global Investors.)

As Michael Porter, a Salomon Smith Barney managing director who follows closed-end funds and ETFs, points out about ETFs (whose advantages I discussed last week), "once you go international with ETFs, you've got to kind of put a certain discount on each of those [advantages], to a greater or lesser degree."

TSC fund columnist and investor advocate Mercer Bullard, while a fan of ETFs, including the international ones, has also wrestled with Barclays about how well the firm informs investors of the premium/discount risks. (See this story on his Web site about the problem.)

The primary concern is volume and liquidity -- and what the lack of each does to pricing. That's especially key for international ETFs, which often represent illiquid markets, like Malaysia or Singapore. The second concern specific to international ETFs is the time difference between the underlying markets and the U.S. market where the ETFs trade. When the markets are not open at the same time, it's difficult to measure how the ETF price compares with the underlying portfolio.

Volume/Liquidity

The volume situation is not as dire as a glance at a Yahoo! quote might indicate. If you look at the volume in, say, the South Korea ETF (EWY Quote) or the Mexico ETF (EWW Quote), on Yahoo!, it might show only a few thousand shares, or perhaps even zero shares, traded for a given day. Yikes!

Yet investors should not "equate the volume issue with the inability to get shares," says Porter. A low volume figure doesn't mean a retail investor would have trouble liquidating a position, or that they could only do so at a price far from the underlying net asset value of the shares. That's because specialists and market makers in the fund can create liquidity without causing as much turmoil to pricing -- the bid/ask spread -- as might occur with a regular share of stock, because of the so-called "create/redeem" mechanism with ETFs. These major market players can "redeem" shares of the ETF for the underlying shares of stock, or "create" shares of the ETF by assembling the underlying shares and then trading those for an ETF share. Through this arbitrage mechanism, they keep the price of the fund in line with the NAV.

It can get trickier when lack of liquidity in the underlying markets makes it harder for a market maker to assemble a basket of stocks for the creation/redemption process, according to Feng Ding, a senior portfolio manager for Barclays. However, Ding maintains that the issue only affects big institutional trades; a market maker can handle a small retail trade without impacting the spread because it will not have a big effect on the amount of risk the market maker has to take on, she says.

The Time Factor

The second issue is time difference. With emerging markets where there is no time overlap with U.S. markets, for example, a decent discount or premium to the underlying value of the shares may develop during the course of the day in the U.S. However, the underlying shares are likely to open the next day at a price that reflects the activity that drove the ETFs. "The imbalance corrects itself quickly because of efficient markets," says Porter, adding that the more liquid the market, the more efficient. "It's just statistical noise. The next day it gets corrected." Still, during our market hours, it's not easy for a U.S. investor to gauge how well the ETF is pricing.

What You Can Do

Unfortunately, neither the Amex nor Barclays Web sites explain these issues well, nor do they give investors insight on how to assess the potential risks. The Amex acknowledges it's got work to do. "It's a question again of getting better information out there," says Cliff Weber, the Amex's senior vice president of new-product development. "The real question is, what's the fair price? It's obviously a much less simple answer for the international products than it is for the domestic."

The Amex is currently working on a study with UCLA to assess ETFs and help provide ways that individual investors can do the same. But while study results are close at hand for domestic ETFs, it will be "several months" before there are more answers on international ETFs, Weber says. For its part, Barclays is planning a relaunch of www.ishares.com that supposedly will have more info for investors -- including info that Barclays agreed to provide in response to Bullard's criticisms.

What to do in the meantime? The iShares site has a page, the "daily NAV/closing prices," under Data & Tools that offers a premium/discount calculation for its funds. However, the NAV is based on the last trade in the local market. For markets closed during U.S. hours, it's not a very helpful comparison.

Another option is checking out the IOPV, or the "indicative optimized portfolio value" of a foreign ETF, a figure that's updated throughout the U.S. market day and is meant to track closely to a fund's NAV. (Amex doesn't make the symbol for each fund's IOPV easy to find, but I tracked it down here.) You can then call 1-800-ishares or a broker to get the bid/ask spread on the ETF -- the spread is not available on mainstream delayed quote services -- and see how close the spread is to the IOPV. Ideally, you want to see the IOPV falling somewhere between the bid/ask, showing that the ETF is tracking closely to the NAV. (Don't put too much stock in this exercise for markets that are closed when the U.S. is open, though.)

All of which brings me to this conclusion: If you are considering an ETF in an illiquid market, like a Singapore or a Malaysia, don't let these liquidity issues stop you outright. These are transparent securities -- the stocks the funds include are publicly known and mechanisms are in place to keep prices competitive. However, be aware of the premium/discount factor that might arise when you place your trades. (This page includes studies from Bullard's site on the matter.) If you are hesitant, consult an adviser or limit your investment until you have a feel for how these instruments work and we all know a bit more about the traps one might encounter.

Discount Details

Reader Richard Golub pointed out that online brokers often don't have information on a closed-end fund's discount to net asset value. "Yet buying at a good discount is the prime reason for purchasing a closed-end fund," says Golub.

I can't excuse the discounters. But try www.cefa.com, the Web site of the Closed-End Fund Association, which tracks the premiums/discounts of closed-end funds. Just input the fund's symbol. (For an explanation of the concept of premiums and discounts to net asset value on closed-end funds, please see this column.)

Broker Talks Back

After I gave online international broker Globeshare less than A's a couple of weeks ago, based partly on its commission schedule being too complicated, the firm's COO, Karl Faulstich, offered this response: "While I agree with you that our commission schedule is not straightforward, it's set up that way so as not to take advantage of the client. ... It would be simpler and neater to post one price per market, but isn't it more important that we provide a better price and a lower execution cost, rather than just keeping it simple? While we Americans tend to favor models which are built on the 'keep-it-simple' approach, global trading is not that simple, and it will be the consumer, in the end, that will pay a much higher price for foreign ordinary shares as a result of our wanting 'the simple price.'"

Well put, and I'm glad to share the point.

Canada Counts

Reader David Hamilton notes that "with many Canadian stocks listed directly on the NYSE or the Nasdaq, U.S. investors might want to get access to corporate filings in Canada." He points to www.sedar.com, which, like our www.sec.gov, has corporate filings.

The Downsides

Throughout this series, several readers have pinged me about the risks of investing overseas: currency fluctuations, political turmoil, lack of regulatory protections and the idea that "diversifying" with overseas investments often doesn't work (see the current global malaise). All real issues, and collectively, they're the reasons I've advocated that investors work with firms that have some expertise in this thorny area, rather than adhere strictly to the "do it yourself for less" online investing mantra. If you are going to venture forth, consider taking a gander at CNBC 24/7 Trading , a book that treats foreign markets and some of the topics this series has discussed.