ETF (Exchange Traded Fund) is a financial instrument that contains a set of financial assets. Apart from stocks, an ETF may include bonds, precious metals such as crude oil or gold, and different currencies. In 2021, the money invested in ETF instruments around the world reached US$ 9.9 trillion. Although ETFs are similar to mutual funds in many ways, they differ in that they can be listed and traded like any stock on the stock market. This means that an ETF, like any stock, has a price that fluctuates during the session. The prices of mutual funds are determined at the end of the day. An ETF can be managed actively or passively. Let me underline that the transaction costs of passively managed ETFs would be more affordable. In addition, ETF holders can also receive dividends distributed for stocks. ETFs that follow indices such as the S&P 500 are the closest financial product to the cheap index funds preferred by small investors in the USA.
Why should I add foreign assets to my portfolio?
In a previous article, I stated that the best strategy to achieve financial independence quickly is a high savings rate and passive index investment in foreign markets. My original approach to financial freedom involved investing in USA capital markets via low-cost ETFs. However, I waited a while to learn how to do that efficiently and accumulate adequate capital. Finally, I invested in Ireland-based S&P 500 ETFs via the London Stock Exchange two years ago. Before then, I had temporarily focused on Eurobonds and Borsa Istanbul. Let’s continue on to why I should invest in overseas markets.
Country risk
I think acquiring foreign financial assets will reduce the risk to my overall portfolio. Unfortunately, Turkey is a developing country dominated by populist politicians. I do not believe this phenomenon will change in my life cycle or even the next generation, even if I wish otherwise. Just acquiring Turkish assets also means taking on the country’s risk. However, by diversifying my portfolio with foreign financial assets, as the Modern Portfolio Theory implied, I can reduce the country risk I take.
If this argument doesn’t sound convincing, I suggest you look at the rich and famous. You’ll find that the rich all have real estate, bank accounts, and investments in Europe or America. If you do a Google search on the foreign wealth of our politicians, I’m sure you will find surprising results. It is always helpful to remember the words of Ziya Pasha, one of the most influential statesmen of the Ottoman Empire, who lived in the 19th century. He said, “A person’s mirror is his works; words are not looked at because the level of one’s mind is revealed only by his works.”
Low rate of return
Another crucial reason I want to invest abroad is the low long-term average return rate of investment instruments in Turkey. That might seem to be counterintuitive. Usually, people believe emerging markets offer excellent opportunities. That might be true for some specific period and for a particular asset class. Satisfying both conditions, however, are complicated. I have done a detailed analysis on this topic. Unfortunately, in dollar terms, risk-adjusted long-term rates of return on Bist100, real estate, and local currency-denominated bonds are low. Gold and Eurobonds provide better results though they can not match the average long-term rate of return of the S&P 500. I suspect many emerging markets have a similar problem.
Technological progress
The key to lasting economic wealth
American economist Paul Romer received the Nobel Prize in 2018 for his contribution to the theory of economic growth. He shows that technological innovation is a major source of growth. The traditional Solow theory of economic growth predicted that developing countries would catch up with developed countries. However, empirical studies have shown that few developing countries have per capita income levels converging to that of developed countries. While technological progress is an exogenous variable in the Solow model, it is internal in the new economic growth model. In other words, the new theory says that R&D and technological innovations carried out within companies in free market economies are the keys to creating permanent economic growth. In addition, knowledge is essentially different than the classical concept of capital. When you use the information continuously, the marginal return does not decrease. Countries that systematically implement scientific work, R&D, and technological innovation activities are like constantly accelerating cars. It is challenging for those behind them to catch up.
Turkey’s situation
In the 18th and 19th centuries, the economic divide between Europe and Turkey increased in favor of Europe. Thanks to Turkish modernization and the breakthroughs made in the Republican period, Europe could not raise the gap in the 20th century. But Turkey couldn’t catch them either. The distance remained the same. Let me give an example of the countries that have closed the gap. 50 years ago, South Korea’s per capita income was half that of Turkey’s, but now it’s almost 4 times that of Turkey’s per capita! In my opinion, the most critical reason for catching up is our companies’ inability to innovate at the desired level. The answer to the question of why is too long. For a more comprehensive explanation, I suggest you look at the book Why Nations Fail by Daron Acemoğlu, a Nobel laureate economist.
What does this mean for the investor?
What does this have to do with personal finance, you might ask? Let me put it this way: There has never been a company like Apple, Intel, SpaceX, Tesla, Google, Amazon, Alibaba, Huawei, Samsung, Sony, or Facebook from Turkey. It’s unlikely to happen for the rest of my life. Therefore, if I had only invested in companies in Turkey, I would not have benefited from the significant investment opportunities brought by technological progress. After all, in the long run, stock markets reflect economic reality. In the last 20 years, the S&P 500 has quadrupled in dollar terms, while the Bist100 has remained the same.
As a result
You should not restrict yourself to your home country. There are more profitable opportunities out there. One of them is US capital markets. At least until US technological dynamism dies out, investing in US firms will be profitable. More than others. One quick and cheap way to invest in US firms is to buy ETFs tracking the S&P 500 index.