Should You Invest in an Offshore Fund?
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Funds can be a great way to benefit from the rise of a market without trying to pick the winners — a hard game even for professionals. But what about offshore funds — those based outside the US (usually) that may give you access to investments not available stateside?
At first glance, this would seem a great way to start investing internationally. And, in some cases, it can make sense. But it’s not for everyone.
In this article, I’ll give you an overview of the case for and against offshore funds from an American perspective.
Among other things, you’ll learn when to use them, why not to, and four ways to bank gains in an offshore fund either tax-deferred or entirely tax-free.
What Are Offshore Funds?
To start with, we should quickly define what an offshore fund is.
In brief, they are investment vehicles established outside the US that trade on a foreign exchange (although some offshore funds also trade on US exchanges). They are often set up in countries with lower taxes and easier regulations. That’s not to say they carry any more investment risk than something available in the US, but rather offer greater tax efficiency for global investors than a US-based fund.
For US investors, offshore funds give you the opportunity to diversify some of your holdings outside the US without having to actually leave the US.
Types of Offshore Funds
Funds available offshore are much the same as what you’ll find here in the US. That includes Mutual Funds, Hedge Funds, Private Equity Funds, Money Market Funds and so on.
Benefits of Offshore Funds
Officially, offshore funds offer the following benefits:
#1: Investment Portfolio Diversification
They give you access to a broader range of investment opportunities across global markets. This is supposed to reduce your reliance on the local (US) markets.
#2: Potential Tax Advantages
Depending on how (and where) they are structured, offshore funds can offer tax deferral and other benefits within the fund. This can mean a better gross return on the investment itself.
(Note: This does not mean you get any personal tax benefit unless you structure your holdings as outlined below.)
#3: Access to Global Markets and Expertise
In the past, investing in offshore funds allowed Americans to benefit from opportunities not available in the US. In practice — with few exceptions — that’s no longer true. There’s a wide range of US-based options to give you international exposure. And often at a lower fee.
The trade-off for this convenience is the risk that the US company you’ve bought from doesn’t actually own / have a claim on the assets they say they do. (A lesson many people had to learn the hard way during the 2008 financial crisis.)
Nowadays, it’s more accurate to say that investing through funds internationally gets you closer to the source and gives you a stronger claim over the assets you’ve actually bought.
The Risks and Challenges
A core maxim of any investment strategy — whether domestic or offshore — is that you need to think about and balance risks.
Because the truth is, every investment strategy (even keeping cash in the bank) comes with risk. As you build more wealth, you have more risk.
When it comes to offshore funds, here are a few sources of risk that domestic-only portfolios don’t have…
Foreign Regulation
Offshore funds are regulated by the country in which they are set up, which can differ quite a bit from US regulations. If that country or its regulator changes the rules, it might affect your holdings.
Foreign Political Risk
This can also be an issue, although to be fair, most offshore funds tend to be set up in places that prize a stable political system. (A very different situation than today’s America.)
Currency Risks
Investing in offshore funds held in a different currency can be both a blessing and curse. If the value of the currency goes up against the dollar, you enjoy a better return. But if it drops against the dollar, this hurts your return.
Costs and Fees
Offshore funds may come with higher costs and fees compared to domestic funds. These can include management fees, transaction costs, and other expenses, which can reduce overall returns.
Issues with Foreign Funds and PFIC Rules
In an effort to avoid hurting domestic competitors, Uncle Sam makes investors report any offshore funds they hold. Not only that, but the tax treatment on any gains can actually be worse than on the domestic side.
Watch out for foreign funds posing as US-based
PFIC rules don’t just apply to offshore funds purchased offshore. In fact, there are a number of foreign funds that trade on US exchanges… and are subject to the same PFIC rules. It’s a good idea to check the “domicile” of any fund before you buy.
A Warning to Americans: Handle Offshore Funds with Care
For the last reason mentioned above — tax issues and PFIC (Passive Foreign Investment Company) rules — we mostly recommend that US clients do not invest in offshore funds. But there are a few exceptions:
#1: If you are dealing with a company that understands how to deal with US tax obligations. They will give you the information you need every year to enjoy the lowest tax treatment.
#2: If you are willing to make a large enough investment in a certain type of fund investing in something you simply can’t find stateside.
#3: If you can invest in a way that lets you legally avoid the rules.
One way to do that is by investing through an IRA or a Roth IRA. Because IRAs are tax-deferred or tax-free, the IRS lets you off the hook for any disclosure or tax filings.
The second way is by using tools like a Private Placement Life Insurance Policy or a Private Placement Variable Annuity. Both of these tools allow you to hold investments in a way that aren’t subject to the same tax treatment or reporting requirements.
How to "build" your own fund
If you really like the idea of a fund but you can’t use a retirement account or insurance policy, one strategy our clients have used is to move some of their assets internationally and then work with an asset manager to build a portfolio that invests in the same stocks or bonds as the fund. That’s because individual stocks and bonds don’t come with the same disclosure requirements.
Feel free to reach out to us if you’re interested in exploring this.
The Right Way to Invest Internationally?
Working with select partners, we’ve helped thousands of customers or clients internationalize their assets over the years. Sometimes offshore funds play a part. Other times they don’t.
If you’re wondering if they might be part of your Plan B, please book a free, no-obligation call with one of our Associates to explore further.
About The Author
Need Help?
We have 40+ years experience helping Americans move, live and invest internationally…
Need Help?
We have 40+ years experience helping Americans move, live and invest internationally…
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