Globalization is knitting separate national economies into a single world economy. As economic integration increases, the cost of information about other countries' companies and assets decreases. Individuals and businesses gain greater freedom to take advantage of foreign economic opportunities. As a consequence, cross-border investments have increased throughout the 1990s for experienced and institutional investors.
Yet despite the large volumes of cross-border investment flows, the world capital markets are still far from fully integrated. Even though cross-border trade in equities has been growing at 20 per cent a year over the past five years, retail investors account for only a small fraction. The European Commission reports that small European investors are reluctant to venture outside their domestic markets. Investors still have a substantial "buy local bias" because the cost of getting enough information about foreign markets is still too high. Thus, many European investors are missing out on more effective investment alternatives. But this is about to change.
Since the mid-1990s, technology and deregulation have worked a virtuous circle to spur cross-border investments. According to the IMF, world foreign portfolio investment flows -- financial investments that result in less than 10 percent ownership stakes in any one company -- shot up from $219 billion in 1990 to $1.4 trillion in 2000. These flows have risen as countries have expanded their stock markets, debt has become securitized, and financial wealth holdings have risen. The National Foreign Trade Council reports that in 1999, market capitalization of foreign firms was more than $3 trillion on the New York Stock Exchange.
There are good reasons for investing overseas but the best one is diversification. Studies have shown that placing up to 20 percent of your assets in foreign stock reduces the risk in the portfolio without lowering returns. By neglecting foreign assets, European investors are passing up the chance to achieve higher investment returns. According to the European Commission, the opportunity cost of the "home bias" is Euros 130 billion. This potential windfall could be unleashed once European financial markets are fully integrated.
Although this situation is not unique to Europe, it has been historically easier for U.S. investors to buy stocks traded in different exchanges. Thanks to a large number of U.S. mutual funds with an international focus it is now relatively easy for U.S investors to invest overseas. According to the Wall Street Journal, "This year, U.S. investors have poured about $4.25 billion into international stock funds, representing 61 percent of the net dollars flowing into all stock funds."
In Europe, differences in currency, language, and fiscal and legal systems have resulted in a lack of transparency and high transaction cost for small European investors wanting to invest abroad. Europe's markets are fragmented along national lines with nationally based exchanges, trading and clearing. For example, to trade the 50 most liquid stocks in Europe, a dealer must belong to eight exchanges and maintain enough staff to deal with multiple regulatory and clearance and settlement systems.
Yet there is hope. The European stock exchange marketplace is in better shape than ever. After going through rough times, the three main European bourses -- the London Stock exchange, Euronext and Deutsche Bourse -- have seen their earnings rocket even as the value of their member companies declined. Because trading on these exchanges is now done electronically, execution costs are reduced. Some say that the European stock exchange industry is ripe for consolidation and cross-border alliances. Of course, a pan-European exchange would lower the cost of trading in Europe. Unfortunately, because the stock exchange generates revenue for government coffers, regulators have an incentive to corral trading in their own country and thwart efforts to consolidate markets across borders.
Until a pan-European exchange becomes a reality, some competitors have nevertheless targeted this opportunity by lowering the cost for EU investors to buy outside of their borders. For instance, NASDAQ (the world's largest electronic stock market) launched the NASDAQ Deutschland stock exchange. With a focus on retail investors, NASDAQ Deutschland trades the stocks in the NASDAQ 100 and Dow 30 along with stocks from the M-DAX, the DAX and the Tech DAX. With an accessible model for every citizen, it decreases the cost of buying stocks of U.S. companies for small investors.
Another break for small investors came with the launch in January 2003 of the NASDAQ 100 European tracker (trading under the symbol EQQQ). Specifically structured for the European market and denominated in euros, this exchange-traded fund is designed to closely follow the NASDAQ 100 index, thus allowing European investors to have low cost access to some of the world's most desirable companies.
Finally -- and ironically with 60,000 multinational corporations with 500,000 foreign affiliates -- when Europeans think they are buying local firms they are more often than not buying at least a partly owned foreign operation. Today, when a German citizen buys stocks in Daimler-Chrysler, he is buying German and American. Much of the growth of companies such as the French pen and razor maker Bic, or Korea's Samsung Electronics comes from the U.S. market. Soon it is going to be hard to tell the nationality of a company. This means that European investors will increasingly be unknowing participants in a worldwide trading market.
The world's trading markets are constantly changing through the forces of technology and globalization. Pure electronic auction markets are no longer a myth and online accounts have changed the nature of trading. Globalization forces corporations and individuals to transcend national boundaries. Yet small European investors are reluctant to invest their money outside their domestic markets. By restricting their choices to domestic assets, they end up missing on more cost effective investments.
However, things could be changing soon thanks to the first step toward a more integrated European financial market. Let's hope that small European investors will soon embrace these opportunities and reap the benefits of cross-border investments.