Difference Between FDI & Portfolio Investment
Foreign investments can be of two sorts. The first is when a firm or an individual buys another firm with full, or very substantial, control of its operations. This investment is called Foreign Direct Investment (FDI).
The other type of investment is called portfolio investment. In such an investment, investors purchase stocks of a number of companies with the objective not to gain management control, but to construct an investment portfolio.
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Purposes
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The purposes of FDI and portfolio investments are different.
FDI allows investors to be actively involved in their investment. Investors not only can take strategic decisions like what their foreign subsidiary will produce, in what quantities and for whom, but also are involved in operational issues like cost control, HR, and regulatory compliance. Investors may be motivated by different reasons including improving operations of their existing businesses, and closely monitoring and safeguarding their investments.
Investors who decide to put their money in portfolios, are pursuing different objectives. They want to spread the risk, without the need to learn about how to run different businesses.
Investors
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Individuals and companies making FDI and portfolio investments are usually very different investors.
FDI investors are often big multinational companies, social organization (NGOs), governmental or quasi governmental organizations (e.g., USAID) and venture capitalists. They either get into partnerships with local enterprises, set up affiliates, or make acquisitions of a foreign companies.
Portfolio investors are mutual funds, hedge funds, pension funds, and other investors who wish to diversify their investments and not get involved in the day-to-day running of the companies they buy into.
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Risks
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The risks associated with FDI and portolio investment primarily are country risk and currency exchange risk. The country risk includes political and economic instability (revolutions, nationalization, tax hikes), and corruption. The currency exchange risk occurs when the exchange rate of the country that has been invested in moves sharply against the exchange rate of the home country.
It is necessary to note that even if investments (both FDI or portfolio investments) are denominated in the home country currency (e.g., U.S. dollars), investors still bear the exchange rate risk to some degree because the cash flows their investments generate will need to be converted into the home currency and if the exchange rate has moved substantially, the returns will suffer.
Portfolio investment, however, has additional risk, namely conflict of interests between portfolio investors and control investors. Investors who have a big enough share of an enterprise can appoint the management of the enterprise that will, accordingly, pursue their interests vigorously, sometimes even acting to the detriment of minority, i.e. portfolio investors.
Returns
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Returns on FDI and portfolio investment are in line with average returns in the country they are invested into. However, portfolio investments are more liquid, which normally leads to higher valuations. But, on the other hand, FDI does not suffer from being a minority investment, which should give it the so-called control premium. On balance, though, FDI and portfolio investment have similar returns.
Macroeconomic Impact
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Portfolio investment is much more volatile than FDI. In periods of crisis, foreign portfolio investments are the first to leave the country, putting downward pressure on the domestic exchange rate, often causing depreciation of the currency of the country from which they are withdrawn.
The underlying reason is that the market for portfolio investment is much more liquid, making it easier to take it out of a country (unless the country in question introduces capital controls, which is not good for its reputation).
Because of this, FDI is a preferred source of capital, especially for developing countries.
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References
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