Making your money work for you is the cornerstone of any retirement planning.
Investment planning can be quite a complicated subject, and indeed there are many financial advisers that seek to make things all the more complicated in order to discourage the laymen investor.
In reality, investment planning can be distilled down to some simple concepts and followed passively by anyone.
The core points to understand when setting up an Expat Investment Portfolio are:
- Choosing a Broker
- Understanding ETFs
- Understanding Passive Funds & Managed Funds
- Understanding US Withholding Tax
- Choosing Your Asset Allocation
Choosing a Broker
The first step to setting up an investment portfolio is choosing a broker.
The first important distinction to make here is that if you are a US citizen there are many US based brokers that are available to you. Non US citizens have fewer options available and the two seem to be, in my experience, mutually exclusive in so far as US brokerages only allow US Citizens to open accounts, and NON-US Brokerages only allow NON-US citizens to open an account.
For Expats, my research turned up 2 viable brokerages that have access to the main exchanges and allow NON-US citizens to open accounts.
The account opening process with SaxoBank was somewhat easier as all documents could be sent off via email.
As I recall, TD Direct, required me to send a notarized copy of my passport to their head office in Luxembourg, at a cost of a few hundred dollars.
I ultimately decided to open an account with SaxoBank, but I must say their customer service has been quite bad with unclear pricing on fees, account restrictions, and lack of clarity in communications.
For Non-US citizens, it would seem we are stuck with a slew of expensive and sub-par brokerages.
For all their failings, SaxoBank remain the only viable option that I would recommend… until a better broker comes along.
Points to look for in choosing an online broker are:
- Access to wide range of markets
- Range of products, including ETFs, Stocks, etc.
- Low commission on trades
- Minimum account balance below your investment level.
ETFs are Exchange Traded Funds, as their name suggests they are Funds that are Traded on Public Exchanges.
What that means is you can buy and sell the funds exactly like you would buy and sell a stock.
This has numerous benefits, such as the increased liquidity of the funds meaning you can open and close positions quickly and easily and also has no “minimum investment” amount such as many mutual funds have.
The downsides the ETFs are that as an exchange traded product they come with the Buy-Sell spread which on low volume funds can be fairly wide. However for an investment window of anything more than a few weeks, this doesn’t pose much of an issue.
ETFs can be considered like a basket of underlying securities, traded as one item.
The underlying components of an ETF can be almost anything, including: Stocks, Bonds, Precious Metals, Real Estate, Mortgages, Commodities, etc.
This allows you to invest in a broad area such as “US tech” or “Developing Markets” and hold a well diversified basket of investments in your target investment.
For most passive retail investors, ETFs are the holy grail that make up the bulk portion of an investment portfolio.
The ability to set up a well diversified portfolio of different investments with a low amount of capital means that a portfolio consisting of a range of ETFs can offer a substantial range of sector and geographical diversification, as well as tailoring your portfolio to your individual attitude to risk.
For example you may wish to hold a portfolio that tracks over 2,000 US stocks, alongside an ETF that tracks US Government Bonds, and Gold.
To establish such a portfolio with individual stocks, bonds, and commodities would mean making thousands of individual purchases and would require a substantial amount of capital to achieve.
ETFs allow you to buy in to a share of a collective investment in the same underlying assets, meaning you can essentially diversify an investment into thousands of individual stocks, from as little as a few dollars, depending on the traded price of the ETF.
Understanding Passive Funds & Managed Funds
So now we understand that ETFs are essentially a basket of securities that trade in one fund, we need to understand who holds that basket and chooses what is held inside of it.
ETFs can be broken down into 2 distinct types:
- Managed Funds
- Passive Funds
As the name suggests, managed funds are funds that are actively managed by investors.
That is to say, the underlying securities in an ETF are selected by an investment manager and the underlying securities may be sold, bought, or swapped, as the investment manger sees fit.
The benefits of managed funds are that you have a professional investment manager managing your funds and can, theoretically at least, manage your money in a smart way to deliver higher returns.
The negatives of managed funds is that they come with higher fees to cover the active management, and as such you need your investment manager to consistently “beat the market” with your investment in order to at least cover the management costs.
An actively managed fund is VERY dependent on the manager to constantly make the right investment choices.
Passive funds are the opposite to active funds and have no direct management.
A passive fund tracks a selection of securities and does not have any active management to buy, sell, or swap the underlying securities.
A passive fund simply tracks the underlying securities with no attempt to manage the funds to produce higher gains or reduces losses.
The benefits of passive funds are the substantially lower fees owing to the lack of managerial oversight, and the fact that a passive fund will track the market almost exactly, without the risk of an investment manager trying to “beat the market”
That is to say, a passive fund that tracks the FTSE100 will perform as well as the FTSE100 over the same time period, no better, but no worse.
A passive fund has no dependence on any single investment manager and relies on the very diversified set of underlying securities, massively diversifying your risk.
Understanding US Withholding Tax
This is where things start to get difficult.
For more detailed advice, you would be well advised to speak to an accredited tax consultant in your country of residence.
However there are some things to bear in mind.
The capital gains realized as a result of selling off a portion of your portfolio will typically be taxed under your local CGT rate.
Dividends will also, typically be taxed at your local income tax rate.
US Non-Resident Alien Withholding Tax
Something Important to bear in mind here is the US Non-Resident Alien Withholding Tax Obligation.
Any US domiciled fund or stock that pays out a dividend will fall under this and any dividend distribution will be subject to 30% withholding tax.
Steve owns 1,000 in “Example American Domiciled ETF”
The ETF pays out a dividend of $100.
Steve receives the $100 dividend -$30 in withholding tax applied by his brokerage.
The default rate of withholding tax is 30% but may well be lower in your country of residence if a tax treaty is in place.
However, this can be significantly mitigated by investing in funds that are domiciled in a country that has a US Tax Treaty in place, for example: Ireland.
Ireland has a US Tax Treaty in place that reduces the withholding tax on dividends from 30% to 15%. See IRS Documentation.
This is particularly important if you hold a fund that contains stocks from multiple countries.
A US Domiciled fund would suffer a 30% tax hit on the sum of the dividends paid out, regardless of the location of the underlying securities.
An Ireland domiciled fund that contains the same mix of securities would pay 15% withholding tax on the dividends of the US domiciled securities, but 0% on the non-US domiciled securities.
Imagine our scenario above in which Steve receives a $100 dividend.
The ETF contains 50% US stocks and 50% international stocks.
If the ETF is domiciled in the US then Steve will pay $30 in Withholding tax, and net $70 in dividends.
If the same fund were domiciled in Ireland, then the US stocks would take a 15% withholding tax, but the international stocks would pay 0%.
Assuming an even distribution of dividend sources, the Irish domiciled ETF would pay $7.50 in withholding tax ($50 x 15%) and net $92.50 in dividends.
As a non-resident US Alien, it makes a lot of sense to avoid investing directly into US domiciled funds that pay out dividends.
There are many funds that trade on the London Stock Exchange that are traded in USD and domiciled in Ireland.
Choosing Your Asset Allocation
Once you have got your head around the above, the fun part begins!
Now you have yourself set up with a brokerage account and have deposited your hard earned money, you are aware of the tax issues, and want to put together a portfolio that reflects your attitude to risk and financial plans.
For most passive investors, a “Lazy Portfolio” is a good way to go.
But all typically follow the same basic premise:
- Broad Stock Market Index Fund
- Broad Bonds Fund
With optional additions of REITs, Precious Metals, Small Cap Funds, Emerging Market Funds, etc…
These Lazy Portfolios make use of passive index funds that track international stock markets and bonds.
Your individual asset allocation will depend on many things such as your personal attitude to risk, your age, and the size of your investable assets.
Stocks are typically more volatile than bonds and produce far higher returns in a bull market, but equally suffer more during a negative market.
As such, bonds are seen as a safety counterweight to your portfolio that are less risky, but produce lower returns than a stock allocation.
As a very, very, broad rule of thumb you should start out with taking your age as the percentage of your portfolio that should be in Bonds…
This advice comes from John Bogle who caveats it by saying it is “a crude starting point” which “[c]learly . . .must be adjusted to reflect an investor’s objectives, risk tolerance, and overall financial position”
For example, if you are 45 years old an have $500k in investable assets, that you do not wish to actively manage and have an investment time-frame of several years, you may look at something like a 60-40 split equities/bonds
If you are 25 years old and have $50k in investable assets, that you do not wish to actively manage and have an investment time-frame of several years, you may look at something like a 85-15 split equities/bonds.
Many ETFs cover international stock markets, holding each at market weight, allowing you to invest in a single ETF but enjoy international diversification.
A personal favourite of mine would have to be VWRD from Vanguard UK.
This is a Global market ETF, domiciled in Ireland, denominated in USD, with a low expense ratio.
The fund has holdings of 48.2% US Market and 51.8% International making it very well internationally diversified.
This makes it a good replacement for VTI+VXUS that are some of the favourite picks for US lazy portfolio investors.
For a broad bonds fund, a good bet would be IUAG from iShares
A US Bonds fund, domiciled in Ireland, with a low expense ratio.
A very simple, hands off passive portfolio could be built from these two funds alone.
Once you are happy with your stocks/bonds allocation, simply split your portfolio accordingly and buy VWRD + IUAG and simply check in every few months to re-balance your portfolio accordingly! The annual expense rate of the total portfolio is 0.25% and over the previous 12 months, at an 80/20 split, would have returned in the region of 13.5% ROI.
Ofcourse, you may wish to build a more complex portfolio to include exposure to other areas such as Real Estate, Precious Metals, Commodities, etc, but as a starting point you could do far worse than starting with the simple 2 fund portfolio above.
As always, you should ensure you do thorough due diligence on any fund before you invest!