J.D. Steinhilber

The Case for International ETFs

A long-standing tenet of investing is that a diversified portfolio should include a meaningful foreign stock component. During the awesome bull market in U.S. stocks in the late 1990's, however, many investors and advisers began to challenge this premise. After all, the returns were inferior overseas and the risks seemed to be greater. Japan's economy and stock market were in a painful, decade-long decline. European stocks repeatedly under performed U.S. stocks. Less developed economies in Asia and Latin America subjected the average individual investor to too much risk. The United States, as the center of the technology revolution, was the place to be, and investors could participate in the growth of foreign economies by investing in the stocks of multi-national U.S. companies.

How times have changed. U.S. stocks are threatening to post a third consecutive year of declines, which hasn't happened since the Great Depression. Meanwhile, foreign stocks are outperforming U.S. stocks and, in some cases, are posting very attractive returns. It is time for many investors to get reacquainted with foreign stocks, and Exchange Traded Funds (ETFs) provide an excellent vehicle.

Foreign stocks deserve a place in an investment portfolio for two primary reasons. The first is diversification. The more an investor can diversify across non-correlated asset classes that historically have produced high rates of return the better. The second reason has to do with some basic economic realities:

• In 1970, U.S. stocks represented two-thirds of the world's equity market capitalization, but today they account for about one-half.
• Companies based outside of the United States dominate several of the world's major industries, including electronics and automobiles.
• For example, 7 of the 10 largest automobile companies and 7 of the 10 largest electronics companies are located outside the U.S.

There are numerous Exchange Traded Funds available to investors seeking exposure to foreign stocks. Not surprisingly, most foreign equity ETFs are sponsored by Barclays, which is based in London and is the largest manager of indexed investments in the world. Barclays offers over 30 international ETFs, most of which are designed to track indices developed by Morgan Stanley Capital International (MSCI). Most of these funds target specific countries. While some of these country funds can provide terrific returns (e.g. the South Korea fund is up 31% year to date), my view is that investors should focus on just two international ETFs: the MSCI EAFE Index Fund (symbol: EFA) and the MSCI Japan Index Fund (symbol: EWJ). Detailed information on both funds can be found at Barclays' ETF web site - www.ishares.com.

The MSCI EAFE Index is a widely recognized international benchmark based on 21 developed market country indices in Europe, Australasia, and the Far East. In addition to 16 European countries, the EAFE index includes Australia, Hong Kong, Japan, New Zealand and Singapore. Barclays' EAFE Index Fund has almost $4 billion in assets and invests in 790 companies.

While the EAFE Index provides broad exposure to the largest foreign companies in virtually all of the developed economies other than the U.S. and Canada, investors should consider combining it with Barclays' Japan Index Fund, which has approximately $750 million in assets and invests in approximately 300 of Japan's largest companies. The Japan Index Fund is a good complement to the EAFE Index Fund because:

• Japan has the second largest economy in the world, after the U.S.
• Japan has a relatively modest weighting in the EAFE index (approximately 10%) because of the large number of countries, particularly European countries, included in the index.
• Japanese stocks have historically had a lower correlation with U.S. stocks than European stocks, so by definition an investor achieves greater diversification benefits by investing in Japan.
• Japan has suffered a protracted bear market for more than a decade and their market may finally have bottomed. The Japan Index Fund (symbol: EWJ) is up over 15% year-to- date.

How much should investors commit to these international equity funds? I think as much as 1/3 of the equity portion of a portfolio makes sense. ETFs provide a low-cost, effective means to achieve this important diversification.