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The Two Best New ETFs of 2007 (So Far)

Vanguard and State Street's two total international-stock funds look solid.

Dan Culloton, 03/13/2007

Until recently, there haven't been many broadly diversified international-stock exchange-traded funds to choose from. Two new funds from State Street Global Advisors and Vanguard have changed that, and they're a long overdue addition to investors' toolkits.

Not the Only Flame in Town
For more than five years, iShares MSCI EAFE EFA has had the playing field to itself. Few ETFs competed with it to provide core foreign-stock exposure, and those that did all lacked something. BLDRS Developed Markets 100 ADR Index ADRD had too much Europe and not enough Asia. WisdomTree DIEFA DWM tracked a new, unproven dividend-weighted index and charged a higher expense ratio. Consequently, iShares MSCI EAFE got the lion's share of the assets. The $39.3 billion ETF is nearly 200 times the size of the next largest rival foreign large-blend ETF and one of the largest international funds of any stripe.

IShares MSCI EAFE does have some positive attributes. As my colleague Gregg Wolper points out in his analysis of the ETF, for a reasonable price iShares MSCI EAFE tracks the most recognized benchmark for non-U.S. stocks and provides instant diversification among many countries in several regions, as well as across different sectors. But the ETF and its benchmark also lack a couple things. The MSCI EAFE has virtually no small-cap exposure and ignores emerging-markets companies as well as those in Canada. Investors wanting to index the entire foreign market with ETFs have had to use emerging-markets or regional or single country funds to make up the difference, incurring more transaction costs and portfolio maintenance hassles as they did so.

Worthy Opponents
Enter SSA's and Vanguard's new offerings: SPDR MSCI All Country World Index (ex-US) CWI and Vanguard FTSE All-World ex-USA Index Fund VEU. Those names don't roll off the tongue, but they could be like music to the ears of ETF investors looking for a way get total international equity exposure in one fell swoop.

State Street launched its ETF in mid-January; Vanguard rolled out its conventional fund and ETF share class last week. Though they track different indexes, both provide similar exposure to virtually the entire world outside of the United States, including both developed and emerging economies, and Canada. That makes them comparable to Vanguard Total International Stock Market VGTSX, a conventional fund of funds that combines Vanguard European Stock Index VEURX, Vanguard Pacific Stock Index VPACX, and Vanguard Emerging Markets Stock Index VEIEX in one portfolio.

Both new funds should make great core holdings. Their portfolios should be pretty similar. Each ETF's index includes more than 2,000 stocks from all major sectors and industries in nearly 50 countries. The market-cap-weighted benchmarks lean heavily on the largest stocks in the world, such as energy giant BP BP, bank HSBC Holdings HBC, and carmaker Toyota Motor TM, but they also have more small-cap exposure than most of the current crop of foreign large-blend ETFs. The funds should behave similarly if not the same, but Vanguard gets the nod for the usual reason: expenses. Vanguard's all-world ETF charges 0.25% while the SPDR levies 0.35%. PAGEBREAK

Long-Term Tools
I'm excited about these new ETFs for the role they can play in a long-term portfolio, not because I think it's a great time to buy international stocks. Indeed, global markets recently gave us a sharp reminder of the risks of international investing (particularly emerging-markets investing) and the benefits of using a diversified approach overseas. On Feb. 27, when panic selling in China triggered a worldwide sell-off, many of the hot performing emerging-markets and sector ETFs for which people had been clamoring bore the brunt of the plunge. The market prices of single country and regional ETFs, such as iShares FTSE/Xinhua China 25 FXI and iShares MSCI Emerging Markets EEM, not only fell hard (by 10% and 8%, respectively), but also ended the day way below their net asset values, which is not supposed to happen with ETFs.

ETF market prices usually trade fairly close to the NAVs of their underlying holdings, but discounts and premiums can open up periodically, particularly in ETFs tracking narrowly defined or harder-to-trade market segments. China and emerging-markets funds certainly meet that description, which helps explain why the iShares FTSE/Xinhua China 25 and iShares MSCI Emerging Markets ETFs ended the day with startling discounts to their NAVs of nearly 9 and more than 4 percentage points, respectively.

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