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International Investing With ETFs

Where we see opportunities internationally and a few things to watch out for.

Michael Rawson, 11/17/2010

All of the speculation surrounding quantitative easing and its effect on the dollar is just the latest in a long line of facts supporting international investing. Over the past 10 years, international markets have returned 5.5% annualized, while the S&P 500 is flat. Not only have they had a better return, but with a correlation to U.S. markets of only 90%, they also offer some diversification benefits. So, it is no surprise that over the past year, investors have withdrawn $53 billion from U.S. stock funds while investing $72 billion in international stock funds. A belief in the importance of international markets is a big reason for Caterpillar's CAT $8 billion acquisition of Bucyrus BUCY, which has 70% of sales from international sources. In this article, we take a look at some ways to gain international investment exposure through exchange-traded funds.

Europe
While the strong fund flows into emerging markets demonstrates investors preference for growth, the eurozone has some appeal, despite the fact that those economies may not be growing any faster than the United States. The European Central Bank, or ECB, has a mandate to maintain price stability, while the Fed has a dual mandate to promote price stability and full employment. That has resulted in restraint on the part of the ECB, which, in turn, has led European consumers to save more and spend less, making them better prepared for retirement. More prudent consumption has also led to a lower current account deficit than the U.S. From a valuation perspective, European equities offer a higher dividend yield than U.S. equities and trade at lower price/earnings and price/book value ratios. There are a few ways to play the strength of Europe with ETFs. Vanguard European ETF VGK offers a very low-cost, index-based approach. It is important to note that although the United Kingdom has a smaller economy than Germany, its capital markets are highly developed and accessible. So, the U.K. makes up about 32% of that fund, while Germany is only 12%. Because Germany has a large current account surplus compared with the U.K. deficit, investors might want to supplement VGK with a single country fund such as iShares MSCI Index Germany Index EWG.

Protection Against Inflation and Currency Devaluation
Turning on the printing press could cause not only inflation, but also a devaluation of the U.S. currency. Don't assume that just because most of your future liabilities are denominated in U.S. dollars, that you will not be affected by a devalued dollar. Internationally traded commodities such as oil, gold, and wheat will be more expensive in dollar terms. By now, investors are familiar with U.S. Treasury Inflation-Protected securities. While that may protect investors from inflation in the U.S., it will not protect investors from a declining U.S. dollar. SPDR DB International Government Inflation-Protected Bond WIP protects investors from global inflation, and because it invests in bonds denominated in foreign currencies, it should provide some protection against a devalued U.S. dollar. While not inflation-protected, the bonds backing WisdomTree Emerging Markets Local Debt ELD are denominated in foreign currencies. This fund uses a somewhat active approach to avoid overweighting weak countries. PowerShares DB US Dollar Index Bearish UDN bets against the U.S. dollar by tracking a currency futures index linked to seven developed market currencies such as the euro, yen, British pound, and Canadian dollar.PAGEBREAK

Overcoming the Home Bias
Investors with a strong home bias--the tendency for investors to be overweight in securities from their home country--may be hesitant to invest overseas because they do not trust the quality of foreign firms. One way to get around this is to tilt toward higher-quality stocks through a fundamental approach such as investing in stocks that pay dividends. PowerShares FTSE RAFI Emerging Markets PXH uses sales, book value, dividends and cash flow to weight stocks instead of market cap. This results in a skew toward smaller and value stocks, and the emphasis on dividends and cash flows helps reduce the possibility of lower-quality financial statements. WisdomTree Emerging Markets SmallCap Dividend DGS invests in smaller-cap stocks from emerging markets but weights them by the dollar amount of total dividends paid rather than by market cap.

Can the Tail Wag the Dog?
Demand for international investment through ETFs has been so strong that it may influence prices of the underlying assets. By some estimates, trading in ETFs that focus on Brazil account for 50% of the daily trading on the Bovespa exchange in Brazil. Strong foreign investment demand and its subsequent withdrawal helped cause the Asian currency crisis of the late 1990s. Unlike that period, emerging markets generally have a better foreign currency reserve and current account position. Today, emerging-markets countries have less debt as a percentage of gross domestic product, or GDP, than their developed-markets peers. Foreign governments have also taken steps to limit the distorting influence of short-term capital inflows. For example, Brazil has tripled the tax that foreigners must pay to access the country's bond market.

It can be difficult to access emerging markets through an ETF, which work best when the underlying assets are liquid. Even though the ETF structure has democratized exotic assets classes, it can do only so much to open up markets that are restricted to foreigners. For example, foreigners are restricted from investing directly in A shares, or mainland listed shares.  This restriction leads these shares to trade at a premium. To get around this restriction in investing directly in the China A shares, funds SPDR S&P China GXC invests in Hong Kong-listed Chinese companies (H shares), while iShares FTSE/Xinhua China 25 Index FXI invests in both H shares and "red chips," or Chinese companies incorporated outside of China. Market Vectors China ETF PEK is a new fund that attempts to give investors direct access to the China A shares market. However, PEK recently traded at a 14% premium and has so far attracted only $29 million in assets. 

Guggenheim BRIC EEB gets its China exposure through another approach; it invests in American depository receipts. The four countries underlying the BRICs account for 42% of the world's population and have the fastest growing middle class. ADRs are exchange listings of non-U.S. companies. However, an investment in an emerging market should give investors exposure to the growth of those markets, not multinational conglomerates, which are typically the ones that issue ADRs. The largest holding in iShares MSCI Emerging Markets Index EEM is Samsung, which with a market cap near $100 billion is hard to think of as an emerging-markets company. Likewise, iShares MSCI Brazil Index EWZ has 15% in multinational Petrobras PBR and another 15% in Vale VALE. For this reason, it may be better to invest in emerging-markets funds that focus on smaller-cap stocks.

Just because emerging markets are likely to experience faster economic growth than developed markets does not mean that they will automatically have better investment returns. We also need to take into account valuations and what level of expected growth is already priced in by the market. Whereas emerging markets sold at a significant discount to developed markets earlier in the decade, they now trade much closer in terms of valuation. On a risk-adjusted basis, emerging-markets stocks appear overvalued. 

Michael Rawson is an ETF analyst with Morningstar.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

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