A Risky Way to Tap Overseas Markets

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Back in 2007 the Australian stock market had risen in nine of the past ten years, making it the world’s most consistent bull market of the decade.

Thanks to strong Chinese demand for Aussie resources, the ASX 200 was outstanding — rising 170% in the ten years to November 2007. But those years weren’t so kind to the US market. The S&P 500 rose just 8.4% during that time, held back by the bursting of the dot-com bubble in 2000 and its slow recovery through to 2007.

After the GFC the results for the two markets flipped. The US market bounced back, spurred on by the Fed’s economic stimulus. It’s been on the up and up ever since. It reached new record highs in mid-2013. Yet the Aussie market couldn’t keep pace, and is still to return to its 2007 peak.

The last few years have been a great time to buy US stocks. And you can add big foreign exchange gains to that for Australians too, with the Aussie falling from US$1.03 in April 2013 to just under US$0.78 today. Not to mention the benefits of having a portfolio diversified internationally.

But there’s a good chance you stayed out of the US market. And there’s a good chance that was because of the high costs of investing on foreign markets.

Earlier this week I got a message from a friend asking how he could affordably trade overseas stocks, US stocks specifically. He was shocked at how expensive the brokerage was.

I agreed that brokerage fees charged when buying and selling international shares are prohibitively high — at least when investing only small amounts in any one stock.

I explained to him that the lowest brokerage fees I could find were around the $60 per trade level — unless you trade very frequently.

But can’t I open a US-based e*Trade account and pay just US$10 per trade?’ he asked.

Well no, not unless you have a US Social Security number…and they don’t just hand those out to Australians.

One way to help overcome the issue is to save up and buy in larger blocks of shares. That reduces the percentage bite that fees will take out of your return. But it could leave you open to the risk of investing in fewer company shares. Another option is to start off by buying internationally focussed Exchange Traded Funds (ETFs) until you build up your equity.

Or you may be tempted to access the US and other overseas markets through contract for differences (CFDs). For a low price, CFDs offer exposure to thousands on US shares and many others on the major world markets.

You need only low levels of funds to get started, as you don’t have to outlay the full amount. They allow you to diversify your limited funds across more investments.

Yet, I must warn you that they leave you open to much more risk than the benefit of that diversification brings.

The Port Phillip office footy tipping started up almost two weeks ago. Ten dollars to buy in. The winner takes the pot in September. It’s a bit of a gamble, but I know that the most I can lose is $10. And I came painfully close to winning last year, so I reckon it’s worth the risk.

CFDs on the other hand… Not. Worth. The. Risk.

Let me first explain what exactly a CFD is. CFDs are a type of derivative. That means that when you buy a CFD you are not actually buying the company’s shares. You don’t have certain rights that a shareholder has, such as voting rights at shareholder meetings. You are not trading the company’s shares, rather products created to trade on a market created by the CFD provider.

Trading on borrowed money

Unlike betting on the footy, and buying regular shares for that matter, with CFDs your losses are unlimited. CFDs use leverage, meaning that they are traded on margin. That means that the amount you invest upfront is just a fraction of your potential losses.

A CFD trading on a 10% margin means that for every $1,000 you put down, you have a $10,000 investment. That means you must borrow $9,000.

This can work in your favour if the share price rises. Just a 10% rise in the share price will double your money. Your position is now worth $11,000. Thanks to the position being leveraged, your $1,000 has doubled to $2,000. This is similar to taking out a mortgage on a property, where any capital gains add to your equity position. But it’s far riskier.

What if the share price falls 10%?

In that case your equity is wiped out. If it falls any further you will owe the CFD provider money. They will make what is known as a margin call, demanding more money immediately. If you can’t stump up the cash they will sell your CFDs, leaving you with no investment and owing money.

This is unlike the property market, where if you go underwater you can simply ignore that fact and keep paying your mortgage. The bank won’t demand you stump up the cash to bring your equity up to certain level.

Counterparty risk

When you buy regular company shares on a stock market the counterparty is other investors. When you buy CFDs the counterparty is the CFD provider itself — the creator and controller of the market. It’s just like at the casino. The house never loses (not at the end of the night, at least).

When trading through an online stock broker, it will act in your interests — trying to get you the best price possible. CFD providers have no such obligation. They will even warn you of this. Here’s what one Australia’s largest CFD providers, CMC Markets said, ‘We will always act as principal, not an agent, for our own benefit in respect of all CFD transactions with you.

Simply, this means that to make sure the house wins they will manipulate the market and take the opposite position against you. And if you do too well, you will be closely monitored.

Big spreads

Liquidity can be very low for many CFDs, even if the underlying company’s shares are quite liquid. This means that bid-ask spreads, that’s the difference between what you can sell for and what it costs you to buy, can be very wide.

It’s similar to the foreign currency exchange booths at airports. You’ve probably noticed the huge difference between what you pay for foreign currencies and what they give you when you sell them back.

Also, low liquidity means your orders may not be executed at the price you want. That’s true even when you use stop losses. The CFD’s price will fall through the stop loss level and could be executed at a much lower prices than you expected. This is known as ‘slippage’ or ‘gapping’. You can pay extra to get a ‘guaranteed stop’ but the high cost is prohibitive, especially when trading smaller amounts.

Sure, the prospect of big wins is tempting. Some investors swear by CFDs, but the average investor is lucky if they come out ahead. In fact, CFDs are so risky that they have been banned in the US.

If you are going to use CFDs, I strongly suggest that you fully understand what it is that you are buying. Also, make sure you have adequate easy access to cash to meet any margin calls. Prepare for the worst case scenario, because these products can have devastating impacts. I suggest only very experienced traders use these products.

If this all sounds a bit complicated then good, leave it to the pros or others with cash to burn. The stocks I recommend in the Australian Investors Club are all high quality investments, recommended only if they meet strict criteria. You can find out more here.

Regards,

Meagan Evans,
Investment Analyst, Australian Investors Club

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Meagan Evans
Meagan Evans, has seen from the inside of the investment industry how easy money can lead to bad management decisions. She holds a degree in Finance and a Master’s in Business Administration and, as a Certified Financial Technician, Meagan employs both technical and fundamental analysis to make solid investment decisions
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