American Expat Financial Problem: What special considerations apply to building an investment portfolio while living abroad?
Fundamental principles of portfolio management apply equally no matter where in the world the investor lives; however, tactical emphasis changes. Local currency and economic conditions need to be factored into the investment portfolio to get the right mix of exposures. Currency and global diversification are the most salient of these factors. To be successful in the long run, investors need to focus on four issues when making investment choices:
1. Currency and Geography diversification:
Currency management strategy is a complement to, but not a substitute for, proper investment portfolio diversification. All investors, wherever they live, need to invest in a broad array of assets, including U.S. stocks, international stocks, bonds, emerging markets, real estate and commodities. Proper diversification can substantially mitigate losses incurred during a severe market downturn. This, in turn, helps sustain portfolio stability and reduces the risk that the investor will sell out near a market bottom as a result of either need or emotion. Decades of academic research and real world investor outcomes confirm that diversification is the only way of maximizing returns for a given level of risk. See the Thun Research article on How Diversification Beat the Bear Market 2000-2009.
Within a broadly diversified portfolio, the relative weight of higher return/higher risk investments (stocks, commodities) versus lower risk/lower return investments (bonds) needs to match the risk profile of the investor. Generally, as we move towards retirement we need to reduce our exposure to a large market downturn by steadily increasing the weight of bonds in our portfolio. Many other factors—job security, near-term spending plans, or expected college expenses for example—also impact this calculation. Building in the right amount of risk is critical to providing the returns necessary to meet planning goals without being overwhelmed by the impact of market volatility.
The ability of professional stock pickers and strategists to “beat the market” has repeatedly been shown to be exceedingly rare. A study of the performance of all U.S. Large Company mutual funds over 20 years found that the average fund underperformed the S&P 500 stock index by 2.6% per annum.2 A European study looking at the period 1975-2006 found that a mere 0.6% of all fund managers succeeded in consistently picking more winners than losers.3 The biggest reason for this dismal record lies in the high fees charged by fund management companies and brokerage firms. With long-run, annual stock market returns averaging around 9%, sacrificing 2.6% of an investment to annual fees and expenses will reduce the total return on an investment by 39% over 20 years. Over 40 years the investment return will be reduced by 62%. This is why investors must pay close attention to the cost of investing their money.
4. Tax Management:
A less obvious but still very serious impediment to long-term investment success is poor investment tax management. Portfolios with high turnover not only incur high commission and trading expenses, but also trigger taxation of capital gains earlier and at higher rates. A stable, low turnover portfolio that defers taxation and benefits from the low long-term capital gains rate will generate dramatically better after-tax returns than a fund that performs equally well on a pre-tax basis but which has high turnover.
Recommendation: Use modern investment tools such as exchange traded funds to build a stable, diversified portfolio with the right amount of risk; manage investments to maximize returns on an after-tax, after-fee basis
These recommendations are especially relevant to Americans abroad because of the unfortunate tendency of many expats to change investment strategies as frequently as they change countries and to pay unnecessarily high investment fees (which are often times hidden in complex derivative structures and nontransparent investment funds). These mistakes are easily avoidable. Modern investment tools such as index mutual funds and exchange traded funds give investors all the tools needed to build a globally diversified portfolio of assets. No matter where they live, American investors working on their own or with the assistance of an advisor can open an account at one of the large U.S. discount brokerage firms and successfully employ these principles to build a winning long-term investment portfolio.
Passive Foreign Investment Company (PFIC) Taxation: What Americans Abroad Need to Know
Passive Foreign Company Investment (PFIC) rules are one of the least understood aspects of the U.S. tax code that directly impact Americans Abroad. The rules are designed to discourage Americans from moving money outside of the United States where it is more difficult for the IRS to monitor investment activity. Any non-U.S. incorporated investment fund that derives 75% of its income from passive activities is by definition a PFIC. This includes virtually all hedge funds and mutual funds incorporated outside the U.S.
The details of the PFIC rules are complex but boil down to a default taxation formula in which all capital gains are taxed at the highest current tax rate (currently 35%). There is no long-term capital gains rate of 15% as would apply to a U.S. mutual fund. To make matters worse, the IRS assumes that all gains were made ratably over the entire holding period, and then assesses interest on the amount of gain that was deferred during the holding period. This formula can easily result in total taxation rates above 50%.
Owners of PFICs can elect an alternative taxation method called “mark-to-market.” This method requires taxes to be paid annually at ordinary income tax rates on the increase in the value of the fund over the course of the year. There is no low capital gains rate and no tax deferral until sale. Finally, losses cannot be used to offset other capital gains!
The point is that PFIC taxation is so punitive that virtually no non-U.S. investment fund is likely to be attractive enough to make up for these negative tax consequences. Nevertheless, many tax preparers are either unfamiliar with the rules or simply unaware of the registration of their clients’ investments. In past decades, this rarely created a problem because the IRS has been lax in its enforcement of the PFIC rules. The new FATCA legislation completely changes this. Now, strict new reporting rules imposed on all non-U.S. financial institutions will require those institutions to provide detailed reporting on accounts owned by Americans. The IRS will be able to easily determine whether investments in those accounts are PFICs.
The legislation increases PFIC enforcement measures, among many other actions designed to stop U.S. citizens from using foreign accounts to avoid taxes.
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