Investment 101: Foreign Direct Investment Vs. Foreign Portfolio Investment

Editorial team of TFX

• 29.06.22 • 5 min read

Capital is essential for economic progress, but most countries can't cover their complete capital needs with domestic resources alone, so they look to foreign investors. There are two main ways to invest in a foreign economy: foreign portfolio investment (FPI) and foreign direct investment (FDI). When it comes to foreign direct investment vs. foreign portfolio investment, FDI means that investors from other countries put their money directly into the profit-generating assets of another country. FPI refers to investing in bonds and stocks of companies that are based in a different country. 

In some ways, FPI and FDI are the same, but in other ways, they are very different. As more and more people invest overseas, they should know the difference between foreign direct investment (FDI) and foreign portfolio investment (FPI). Countries with a high level of FPI can experience more currency turmoil and market volatility during times of uncertainty. Here is what you need to know about FDI vs. FPI. 

What Is Foreign Direct Investment?

Foreign direct investment (FDI) is when a company buys or starts a business in a foreign country. This can be done by buying or starting a new manufacturing company, building warehouses, or buying real estate. Foreign direct investment usually means taking a big, long-term interest in the economy of a foreign country. Multinational companies, venture capital firms, and major organizations are usually the ones who make direct investments in other countries. FDI is often seen as a good thing because it is an investment that will last for a long time and will help the country's economy.

An important thing to consider when choosing between a portfolio vs. direct investment is that direct investments, like building or buying a factory, are harder to get out of or sell. Direct investment is often approached with the same goal in mind as starting a new business in your own country. When an investor makes a direct investment, they have full control of the company they are putting money into and can choose to run it directly. It also involves more risk, work, and commitment than investing in foreign portfolios. In direct vs. portfolio investment, here are some good and bad things about foreign direct investment.

Pros 

• Foreign direct investment can help a company expand into new markets.
• FDI can assist a corporation in mitigating currency risk.
• FDI can help a company capitalize on lower labor expenses in a foreign country.
• FDI can assist a business in diversifying its operations.

Cons

• An investment in a foreign country, when the company has little or no prior expertise, might be risky.
• FDI can be costly because the company may have to start from scratch in a new country to reap the benefits of the investment.
• Due to the need for clearance from the foreign country's government, foreign direct investment (FDI) can take a long period.

What Is Foreign Portfolio Investment?

Foreign portfolio investment (FPI) is the term used to describe investing in a foreign country's financial assets, such as stocks or bonds that are traded on a stock exchange. Since portfolio investments are easy to sell off rapidly and are often considered short-term attempts to gain money rather than long-term investments in the economy, this sort of investment is sometimes seen less positively than direct investment.

However, you should know that between direct vs. portfolio investment, portfolio investments often have a shorter investment return time frame than direct investments. Foreign portfolio investors, like any other stock investor, typically expect to benefit quickly from their investments. Portfolio investments are easier to sell off than direct investments because securities are easily traded. Since they involve far less research and investment capital, portfolio investments are easily accessible to an average investor than direct investments. In our comparison of the portfolio vs. direct investment, here are a few pros and cons of foreign portfolio investment. 

Pros 

• Since the business is not investing in a foreign nation and does not need to establish new operations, portfolio investment is less dangerous than foreign direct investment. 
• Foreign direct investment is more expensive than portfolio investment since the company must establish new facilities in a foreign country.
• Portfolio investment takes less time than foreign direct investment because the corporation does not need permission from the government or other entities of the different countries in which it invests.

Cons 

• Portfolio investment may not offer the same growth opportunities as a direct foreign investment because the company doesn't take an active management role in running the businesses in which it invests.
• As the company is not exposed directly to currency risk, portfolio investment may not give the same hedging advantages as foreign direct investment.
• When it comes to portfolio vs. direct investment, you should remember that because the company is not involved directly in the administration of the enterprises in which it invests, portfolio investment may not deliver the same labor cost savings as foreign direct investment.

Examples of Direct Investment Vs Portfolio Investment

Imagine that you are an American multimillionaire searching for an investment opportunity. You are deciding between (a) acquiring a manufacturing company of industrial machinery and (b) purchasing a large stake in a manufacturing company that makes this machinery of industrial machinery.  The latter is an example of portfolio investment, whereas the former is a way of direct investing.

When it comes to direct investment vs. portfolio investment, this example offers much clarity. Now, if the machinery manufacturer were located in a foreign country, say Mexico, and you invested in it, your investment would be called foreign direct investment (FDI). If the firms whose shares you were thinking of purchasing were also headquartered in Mexico, your purchase of their stock or American Depositary Receipts (ADRs) would be considered FPI.

Although FDI is typically limited to major investors who can afford to invest abroad directly, the average investor is likely to engage in FPI, whether knowingly or unknowingly. Buying foreign stocks or bonds directly or indirectly through mutual funds, ADRs, or exchange-traded funds constitutes FPI.

Conclusion 

Understanding foreign direct investment vs. foreign portfolio investment is crucial when investing in a foreign country. While FPI and FDI, can provide a much-needed inflow of capital for an economy, FPI is far more volatile, which can exacerbate economic woes during uncertain times. Retail investors should familiarize themselves with the distinctions between these two major sources of foreign investment, as this volatility can have a considerable detrimental influence on their investment portfolios. Ultimately, the choice between the direct vs. portfolio investment will be determined by the company's goals and ambitions.