International ETFs: Diversification and Returns

Saturday, August 15, 2009

Historically investors have added broad international exposure to a stock portfolio to find higher returns and/or to lower overall portfolio volatility. These reasons are as valid as ever - and as dependent on market cycles.

A handful of solid, well-priced ETFs give broad exposure to mostly large or mid-cap stocks in economies outside the US. The most popular is iShares MSCI EAFE ETF (NYSEArca:EFA), which tracks the widely followed Europe Australasia Far East Index of advanced economies. Most other broad international funds include small amounts of emerging markets. SPDR MSCI ACWI ex-US ETF (NYSEArca:CWI) and iShares MSCI ACWI ex US ETF (NasdaqGM:ACWX) both track about 45 countries in the Morgan Stanley All Country World Index. SPDR S&P World ex-US ETF (NYSEArca:GWL) and Vanguard FTSE All-World ex-US ETF (AMEX:VEU) round out the group with similarly comprehensive coverage. Year-to-date their performance is:

All charge 0.35% in annual fees, except VEU which charges 0.25%. These are all about 0.15% above similarly broad US-only funds, so even in a flat world there is a cost to moving capital. Foreign brokerage firm involvement, paperwork, and currency exchange account for much of it.

Seeking better returns elsewhere makes the most sense when one and ideally several of the following are true: 1) Economic prospects abroad appear better than in the US, 2) Valuations of foreign stocks are cheaper than in the US, and 3) the dollar is more likely than not to decline against a basket of other currencies.

As to whether economic prospects abroad are higher, consensus 2010 gross domestic product projections show Asia leading (spread widely between China's 9% and Japan's 2%) all regions. This is followed by the US at about 2% growth in 2010 and then by Europe at 1% growth. So in terms of economic prospects the US sits in the middle of the pack. Price/Earnings valuations for Asian stocks are a bit high (certainly in China), while valuations for US and European valuations are close to historical averages. Overall, it is an acceptable but not a terrific time to go abroad.

The dollar's low value seems at first a reason to stay home. The Yen and the Euro have climbed to impressive levels, giving the dollar investor less purchasing power. In normal times, the dollar would rebound as investors flock to invest on Wall St. or as international buyers snap up cheap US goods, so all else being equal, US stocks would be preferable. Unfortunately the US government is embarked on an unprecedented spending spree while the Federal Reserve is essentially printing money by buying up vast amounts of Treasuries. Classical economics points eventually to monetary inflation and further weakening of the dollar vs. other currencies.

Portfolio diversification has long been a reason to put a sizable chunk of money in international. Unfortunately, researchers have been noting a steady rise in correlation between US and most other countries' stock markets. The diversification benefit appears to be melting away.

It is fashionable nowadays to say that international stocks are moving in tandem for the first time, but that is not historically accurate. There have been many periods of increasing and decreasing correlation, going back more than a century. In "Long-Term Global Market Correlations" from The Journal of Business, 2006, authors William N. Goetzmann, Lingfeng Li, and K. Geert Rouwenhorst found that:

"The correlation structure of the world equity markets varied considerably over the past 150 years and was high during periods of economic integration." Only now do we call it globalization.

Of particular note is that correlation was found to be strongest just when the investor least desires it: in times of high volatility. On the brighter side, when volatility created by the current crisis subsides as it surely will, correlation should fade somewhat and the benefits of diversification should re-emerge.

There are many other ETFs for playing international stocks in various ways. The following ETFs make it easy to filter for company size and growth/value characteristics:

  • iShares MSCI EAFE Growth ETF (NYSEArca:EFG), annual fees: 0.4%
  • iShares MSCI EAFE Small Cap ETF (NYSEArca:SCZ), annual fees: 0.4%
  • iShares MSCI EAFE Value ETF (NYSEArca:EFV), annual fees: 0.4%
  • SPDR Dow Jones Global Titans ETF (NYSEArca:DGT), annual fees: 0.5%
  • iShares S&P Global 100 ETF (NYSEArca:IOO), annual fees: 0.4%
  • PowerShares BLDRS Developed Markets 100 ADR ETF (NasdaqGM:ADRD), annual fees: 0.3%
  • Vanguard FTSE All-World ex-US Small-Cap ETF (NYSEArca:VSS), annual fees: 0.38%

A number of funds select and filter international stocks based on proprietary formulas using fundamental financial ratios:

  • PowerShares FTSE RAFI Developed Markets ex-US Small-Mid Portfolio ETF (AMEX:PDN), annual fees: 0.75%
  • WisdomTree DEFA ETF (NYSEArca:DWM), annual fees: 0.48%
  • WisdomTree International LargeCap Dividend ETF (NYSEArca:DOL), annual fees: 0.48%
  • WisdomTree International MidCap Dividend ETF (NYSEArca:DIM), annual fees: 0.58%
  • WisdomTree International SmallCap Dividend ETF (NYSEArca:DLS), annual fees: 0.58%
  • WisdomTree International Technology Sector ETF (NYSEArca:DBT), annual fees: 0.58%

The following leveraged funds are strictly for short-term speculative trading:

  • ProShares Short MSCI EAFE ETF (AMEX:EFZ), annual fees: 0.95%
  • ProShares Ultra MSCI EAFE ETF (NYSEArca:EFO), annual fees: 0.95%
  • ProShares UltraShort MSCI EAFE ETF (AMEX:EFU), annual fees: 0.95%

Co-founder of indexfunds.com, author of two books on investing, and founder of ETFzone.com, Will has been writing on indexing issues for 8 years. He holds an MBA from the University of Texas at Austin.