Cross-Border Investment Issues - Essay Example

Introduction Cross border or international investment has gained significant popularity in present times. Shrewd and savvy investors today regard itas one of the pre-eminent portfolio diversification strategies. As a matter of fact, adding foreign financial assets and real estate assets to a portfolio of domestic assets provides the investors an opportunity to take advantage of the economic environment and investment opportunities prevailing in foreign countries. However, using cross border investment as a diversification tool does not only come with substantial opportunities and enhanced returns for the investors. There happen to be several issues associated with adding foreign financial and non financial assets to a portfolio. Investors need to identify these issues and act wisely to minimise the risks involved in cross border investment while maximising the expected returns out of the investment. This paper identifies and elaborates major issues related to cross border investment and viability of this tool in portfolio diversification. Europe is known to be one of the pre-eminent real estate investment destinations for foreign investors. Western European countries such as France, United Kingdom, Germany and Italy etc have remained to be the most favourable real estate markets; however, properties in these countries are extremely high-priced. This is directing attention of foreign investors to the Eastern European countries. These emerging and new markets offer various investment attractions to the foreign investors. Investors from all parts of the world in particular from the UK are taking keen interest in exploring these countries' investment potential. Furthermore, as these countries move towards EU accession, significant growth in their commercial and business activities can be observed. This further adds up to the attraction of these countries as a tool for international portfolio diversification. This paper illuminates the viability of Europe for international investment and the countries in the region that offer huge investment returns for the UK investors. Cross Border Investment as a Diversification Tool Investors in all parts of the world tend to diversify the unsystematic risks involved in various kinds of investment through different diversification strategies. Myer et al. define the term diversification as, "the complete removal of unsystematic risk in an effort to minimize the fluctuations of a portfolio's return in excess of what the market will reward" (1999, p. 163). Diversification in the form of investment portfolio has remained popular among investors for the last several decades. Through portfolio diversification companies and investors invest their funds in several dimensions such as shares, securities, bonds, derivatives and real estate etc. One such strategy becoming substantially appealing to investors in present times is diversification of risk through investment in international financial and real estate assets. Under cross border investment, companies and investors look for investment opportunities around the world and make the most of favourable situation in foreign countries. Investors might opt for either a complete international investment portfolio or a combination of domestic and international financial assets and real estate. Investors are supposed to attain maximum returns out of their invested funds when they diversify the investment over a range of different countries with significant investment opportunities. Research demonstrates that cross border diversification of investment portfolio carries substantial benefits for the investment with respect to risk reduction as well as return maximisation (for example, Addae-Dapaah & Loh (2005); Cheng et al. (1999); Gordon et al. (1998); Sirmans and Worzala (2003) etc.). Cheng et al. affirm this point as, "significant diversification benefits are available when investments are spread out over many different countries" (1999, p. 463). Investors can not only take advantage of favourable situation prevailing in foreign countries but also diversify the risk associated with any investment by investing in less riskier countries having attractive investment opportunities. Gordon et al. (1998) demonstrates that adding international real estate securities to the portfolio of investment proves to be effective in reducing and diversifying risk. Cross border portfolio investment strategy has several advantages over purely domestic diversification. These benefits distinctively vary from country to country and include better investment opportunities, better exchange and interest rates and stronger economic conditions etc (Addae-Dapaah & Loh, 2005). Diversification through foreign investment provides benefits to investors such as differences in foreign exchange rates in domestic and foreign countries, favourable investment environment, attractive interest rates and economic growth. Some countries might offer attractive exchange rates for the investors while others might have better interest rates or stronger economy. In such a situation it is viable for an investor to diversify the investment into several foreign countries so as to attain the maximum returns. Investing all funds into domestic financial assets and real estate, on the contrary, would have very limited potential for high returns. Cross border investment becomes a very significant diversification tool if the portfolio is spread over both emerging and developed economies having investment potential. Addae-Dapaah & Loh propound that "diversifying a portfolio of real estate investment across both [emerging and developed] economies is a more profitable strategy" (2005, p. 240). Factors such as exchange rates, economic conditions, property and asset prices, inflation, laws and regulations vary from country to country and investors can attain substantial gains by wisely diversifying their portfolio of investment across countries with different economic conditions. Hence investment in international financial assets and real estate serves to be a very useful tool in diversifying risk and enhancing the chances of maximised returns. Current Issues In Cross Border Investment Despite the effectiveness of cross border investment in diversifying the risk and increasing returns on investment discussed above, there happens to be several issues associated with this diversification tool. International investment implicates difference countries with different laws and regulations, availability of information and economic scenario. Investors going for diversification of investment across several foreign countries face several problems in coping with national differences with respect to investment scenario. As cross border investment gains popularity as a diversification tool, these issues become more apparent. Creating an efficient portfolio is the most important consideration in cross border investment. Gordon et al. suggest, "a portfolio is efficient when it offers the highest return for a selected level of risk, or alternatively, the lowest risk for a given level of return" (1998, p. 89). The level of risk related to international investment is higher along with the returns because there are several issues that the investors confront while diversifying the portfolio with international investment. Several researchers (e.g. Conover et al. (2002); Addae-Dapaah & Loh (2005); Sirmans and Worzala (2003); D'Arcy & Lee (1998); McAndrews and Stefanadis (2002); Cheng et al. (1999) etc.) have pointed to issues underlying international investment for portfolio diversification. These issues could have serious implications for the investor and might enhance the investment risk instead of reducing it. The most pre-eminent issue that an investor confronts with respect to cross border investment is that of the exchange rate volatility. The foreign country's rate of exchange mainly differs from that of the investor's domestic rates. Hence, any fluctuations in the rate of exchange of foreign country can lead to enhancement of risk of losing investment returns. Addae-Dapaah & Loh put forward that, "exchange rates movements have serious implications on the profitability of international real estate investments through the interplay of movements between the investor's home country currency and the foreign currency" (2005, p. 227). Profitability from foreign investment depends greatly on the rate of foreign currency in which the investor expects the returns. If the foreign currency fluctuates greatly from the rate at the time of investment, there is a significant risk of losing profit. Hence exchange rate volatility can prove the cross border investment as an unfeasible strategy for portfolio diversification. This aspect of international financial assets and real estate portfolio increases the uncertainty associated with the investment. Investors investing in international assets, in particular, shares, bonds and derivatives already confront with price uncertainty. The factors associated with exchange rate fluctuations enhance the investment uncertainty. D'Arcy & Lee says that "currency fluctuations add an additional dimension of uncertainty, which many real estate investors have preferred to avoid" (1998, p. 114). For instance, if an investor invests funds in international real estate and finds a substantial decline in exchange rate of foreign currency after some time. In such a situation investor will bear loss or a reduction in profitability even if the price of property rises in foreign country. Hence international investors remain keen to minimise the risk of exchange rate fluctuation associated with cross border investment. Managing exchange rate or currency risk is a crucial element of international investment. This risk is involved in all kinds of investment fore example securities, bonds, derivatives and real estate etc. However this risk can be managed with the help of a well diversified portfolio of mixed assets. Sirmans and Worzala also say that "for firms with diversified mixed-asset portfolios of international assets, it may be more efficient to manage currency risk at the overall portfolio level" (2003, p. 1099). The currency risk associated with international investment can be reduced with the help of mixed-asset portfolio, but this will further increase the range of foreign investment the investor is indulging in. For instance, a real estate investor can conveniently manage the same kind of investment in foreign countries, but it can be risky to invest the funds in a number of other assets such as securities and bonds etc. Although the level of risk owing to currency rate fluctuations can be diversified through a mixed-asset portfolio yet the ability to manage a number of different investment options appears as a salient issue for the investors. Another issue related to cross border investment is generally of the different method to evaluate an investment option across the world. This renders the investors further incapable of effectively evaluating an investment and estimating the level of risk that is associated with the returns on that foreign investment. Conover et al. point out this issue as, "arbitrageurs may be unable to ascertain the risk and required return of real estate internationally, due to differing appraisal methods throughout the world" (2002, p18). Investors confront with this issue more often in foreign countries and the risk significantly ascends in case of a mixed asset portfolio. Hence, investors need more profound skills to manage foreign asset portfolio as the complexity of different markets increases. Investors opting for cross border investment in order to diversify their portfolio of assets face difficulties in becoming completely aware of the foreign countries' laws and regulatory requirements. This also might lead to a significant increase in the cost of investment in case of complex regulations. McAndrews and Stefanadis propound that "disparities in national rules discourage cross border trading because investors and companies must familiarize themselves with the regulatory regimes of various countries" (2002, p. 3). This issue further elevates if the portfolio is diversified in a number of different countries. Investors therefore need to evaluate the differences that might exist in different countries with respect to laws and regulations as an important aspect of international investment. Investors investing funds in stocks and derivatives of foreign countries should also keep abreast of the cost of information that will add up to the investment. McAndrews and Stefanadis state that "the relatively high cost of obtaining information on foreign stocks is yet another important consideration" (2002, p. 1). Also the reliability and integrity of investment information obtained from foreign countries remain to be an important issue. Although some countries might offer lucrative investment opportunities to foreign investors, yet investors need to evaluate the risks and returns that would come with a particular type of investment in a particular country. There appear to be several strategies that promise risk reduction and return maximisation of international investment, however Cheng et al. suggest that "under ideal circumstances the investor should hold just enough foreign assets to obtain the diversification benefits, but not so much as to allow the riskiness of these assets to dominate the returns of the entire portfolio" (1999, p. 469). Because there are issues associated with cross border investment that enhances the level risks and uncertainty for investors, the portfolio diversification in international markets should be done to the extent that it does not minimise the probability to attain maximum returns. This is only possible if the investor considers all the issues that are encountered in portfolio diversification with the help of cross border investment. Portfolio Diversification in Europe Real Estate Market for UK Investors Real Estate market is booming in almost all parts of the world these days. In Europe, the consolidation and integration of countries has led to rising investor confidence and market attractiveness particularly in the real estate sector. D'Arcy & Lee remark about the integration of European economies as, "such developments are likely to have a significant impact on key elements in that environment such as interest rates, transaction costs, exchange-rate risk, and the potential for real estate portfolio diversification in Europe" (1998, p. 113). Europe has remained an attractive real estate investment destination because of its stronger economy and attractive property prices. For this reason, investors from different parts of the world invest in European property. Jones Lang LaSalle (2006) says that total investment in European real estate market remained to be 200 for the year 2006. It is expected that the market will continue to expand and flourish in the year 2007 with most of the business in the countries like France and Germany. However problem with these countries is that the properties are already high priced leaving no room for small budget investors. Therefore, the most viable option that remains for UK investors to invest in emerging Eastern European countries. Many Eastern European countries' recent accession to the European Union is further enhancing the real estate investment prospects in these countries (EU Accession Key Opportunity, 2007). Due to overpriced property market in Western Europe, many investors are moving to Eastern European countries with attractive investment opportunities. There are several factors that induce investors from all parts of the world. The Eastern European real estate i.e., land, apartments, shops etc have extremely low prices with a substantial potential to appreciate in value in the coming years. Eastern European real estate market is simply booming and is attractive for foreign investors. The climate and the locations attract tourists and so are worth investing. These countries are swiftly converting to Euros, which have enhanced trade and other commercial activities leading to improvement in infrastructure and state of development. All these factors add up to the investment attraction of these countries. Europe continues to be a profitable market for international real estate investors. However, new and emerging markets in Europe are more likely to provide high returns on investment (Jones Lang LaSalle, 2006). There has been increasing tendency among UK investors to add more weighting to European countries in their portfolios. Some Western European countries like Spain, Italy and France have remained as lucrative real estate investment destinations. Spain is one of those European countries that offer attractive property investment options at reasonable prices. Tourist attractions, better locations, high living standard and low property prices make Spain a wise choice for investors from around the world. It is even more viable to invest in rental properties in Span as they offer about 8-10% returns on investment every year (Banerjee, retrieved 11.01.2007). Countries like Ireland, Spain and Sweden will continue to witness a huge investment inflow from foreign investors (Jones Lang LaSalle, 2006). Bulgaria is another European country gaining huge share of investment from foreign countries including the United Kingdom in its real estate market. Besides, the real estate sector of Romania is also becoming popular among UK investors. Bulgaria and Romania offer great investment opportunities to the UK investors and it is expected that the number of property investors in these countries will rise significantly after their EU accession in particular the rental property market (EU Accession Key Opportunity, 2007). The ever rising tourist interest in Bulgaria accompanied with low prices as compared to the Western European countries like France and Italy make Bulgaria a sound choice for investors around the world, especially from the UK. The integration with European Union will further add up to the existing infrastructure and development of the country. Real estate investment in Bulgaria is even said to be generating substantial revenues with about 80% rise in urban property prices every year (Meagher, retrieved 11.01.2007). In essence, both Bulgaria and Romania appear to be having lucrative investment prospects for the UK real estate investors (BBC, 2006) and these countries are likely to bear the same potential for a number of coming years. Among other European countries with high property prices and crowded urban areas, these countries will continue to gain investor attention from different parts of the world. Conclusion This paper discusses the effectiveness of cross border investment as an investment diversification tool. International markets are characterised with exchange rate differences, better interest rates, strong economic conditions and different investment opportunities. Investors can gain huge benefits by capitalising from these differences. Despite the attractive benefits associated with this form of diversification, the international financial and non financial investment might also enhance the level of risk and uncertainty associated with investment. Investors confront with several risks in international markets, for instance, fluctuations in exchange rates, differences in regulatory environment, cost of obtaining information and misjudging the international markets. These risks can substantially reduce the rate of return the investor expects to earn on each investment. European countries occupy a significant position among other countries as attractive investment destinations. UK investors can benefit greatly from investing in Western European countries like France, Spain and Germany etc, but these countries' real estate markets are already over priced. Eastern European countries like Bulgaria and Romania offer significant investment potential to UK investors. These countries have all what constitutes a wise real estate investment for instance, low prices, growing business activities, new and exotic locations, better climatic conditions and numerous tourist attractions. Accession of these countries to European Union further ameliorates the living standards and developmental state of the economy. Many UK investors are turning towards these countries to make the most of low property prices. Hence these are the countries worthy of investment by the UK investors. Reference List 'EU Accession Key Opportunity For Property Seekers In Bulgaria' (January, 2007). Sofia Echo. Bulgaria Abroad. Retrieved January 14, 2007 from the World Wide Web: http://www.sofiaecho.com/article/eu-accession-key-opportunity-for-property-seekers-in-bulgaria/id_19626/catid_69 'Jones Lang LaSalle European Capital Markets Outlook for 2007' (December, 2006). Jones Lang LaSalle: Experience a World of Difference. Retrieved January 11, 2007 from the World Wide Web: http://www.joneslanglasalle.com/en-GB/news/2006/Capital_Markets_Outlook_for_2007.htm Addae-Dapaah, K. & Loh, H.L. (2005). 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