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Yield, Please (Hold the Europe)

We like these international equity ETFs for their yield and relatively low volatility.

Patricia Oey, 12/01/2011

While European leaders try to move forward with a plan to address the sovereign debt crisis, there is plenty of uncertainty as to what lies ahead. Uncertainty begets market volatility, so risk-averse investors looking for exposure to international stocks might want to consider lower-volatility funds with relatively lower European exposure.

To generate a list of all exchange-traded funds that hold international equities and less than 50% exposure to European equities, we used this screen in Morningstar Office (a similar screen can be performed in Principia, minus the Sortino ratio criterion):

US Broad Asset Class = International Equity
And Equity Region Greater Europe < 50

As a point of comparison, the developed-markets MSCI EAFE Index (Europe, Australasia, and Far East) has a 66% exposure to European stocks and the MSCI ACWI ex-US (All Country World Index, ex-US) has a 50% exposure to European stocks.

Next, we added a screen for yield and eliminated ETFs that held REITs:

And 12 Mo Yield > 3
And Global Category does not equal Real Estate Sector Equity

Finally, we screened for volatility:

And Sortino Ratio 3 Yr (Mo-End) > 0.4

International equities tend to be more volatile than U.S. equities, especially in the short term, because of currency effects. Over the past three years, certain categories within international equities have experienced high volatility but strong performance as well. Instead of using standard deviation or the Sharpe ratio as screens, which penalizes both upside volatility and downside volatility, we used the Sortino ratio, which is a measurement of return per unit of downside risk. It is similar to the Sharpe ratio in that it has the same numerator (the return of the portfolio minus the risk-free rate) but instead of using the portfolio’s standard deviation as the denominator, the Sortino ratio uses the standard deviation of negative returns only. In simpler terms, the Sortino ratio only considers downside volatility as risk. For this screen, we looked for funds with three-year Sortino ratios greater than 0.4—again, as a point of reference, the Sortino ratio for the MSCI EAFE Index and MSCI ACWI ex-US was 0.09 and 0.14, respectively.

IShares MSCI Pacific ex-Japan EPP
The easiest way to avoid Europe is to invest in an Asia-focused fund. IShares MSCI Pacific ex-Japan EPP invests only in developed Asian countries, which includes Australia (which accounts for 64% of the fund’s portfolio), Hong Kong (20%), and Singapore (13%), countries with well-developed capital markets and rule of law. Many of the holdings in this fund do business with or are invested in China and other emerging Asian nations, so investors considering this fund should have a long term positive outlook on the region.

But investors can also consider this fund for its diversification benefits. Relative to broad international funds, the fund has a relatively lower correlation to U.S. equities, as most of the large caps in this fund don’t compete with the large cap multinational financial, consumer, energy, and health-care firms from the U.S. and Europe. This ETF also has a heavy 20% exposure to the materials sector, typically underrepresented in broad U.S. equity funds.

A risk to consider before jumping into this fund is the 19% weighting in Hong Kong and Singapore financial firms. Many of these firms are property-development companies with heavy exposure to real estate in China, where prices in certain cities are approaching bubble levels. Investors should also note this fund’s exposure to the Australian dollar through this fund’s Australian holdings. The Australian dollar is considered a commodity currency, whose exchange rate can fluctuate strongly during periods of market volatility. At 4.6%, the fund’s yield is attractive, and its expense ratio of 0.5% is reasonable for an international fund.

WisdomTree Asia Pacific ex-Japan AXJL
This ETF has a similar theme, investing across developed and emerging Asian countries (excluding Japan), but its holdings are dominated by Australian (26% of the portfolio) and Hong Kong companies (19%). Another difference between this fund and the iShares fund is that the iShares fund is a market-capweighted fund, while AXJL takes the 300 largest companies from the Asian region and weights each constituent by annual cash dividends paid. We like the dividend-weighting methodology, which is a straightforward measure of value that is not affected by variances in accounting standards across countries. We also think that dividends can be a sign of good management and corporate stewardship. Relative to the iShares fund, this ETF has a slightly higher dividend yield of 4.9% and a slightly lower expense ratio of 0.48%.

WisdomTree Intl. SmallCap Dividend DLS
This small-cap, developed-markets fund has a relatively low 38% exposure to European securities. Like WisdomTree’s Asia Pacific fund, WisdomTree International SmallCap Dividend weighs its constituents based on annual cash dividends paid. Generally, we like small-cap international stocks for two reasons: lower correlations to U.S. stocks relative to international large caps, and the small-cap premium, which is the tendency for small-cap stocks to outperform large caps over long periods.

Small-cap stocks tend to cater to domestic markets, and over the past 10 years, the correlation between the MSCI EAFE Small Cap Index and the S&P 500 was 80%, lower than the 90% correlation between the MSCI EAFE Index and the S&P 500. The risk for this fund is its large exposure to Japanese stocks (37% of the portfolio). Historically, this large exposure to Japan equities has helped reduce volatility, and the appreciation of the yen against the dollar was the main source of returns for the Japanese equities allocation during the past decade. A slowdown in the yen’s appreciation and continued underperformance of Japanese equities could negatively affect DLS in the future. This ETF’s yield is 4.2% and its expenseratio of 0.58% is in line with internationalsmall-cap funds.

First Trust DJ Global Select Dividend FGD
This developed-markets fund also invests in the United States. The ETF weighs its components by dividend yield, but it first screens for dividend quality to avoid stocks that may be paying an unsustainably high dividend. The fund has a large 19% exposure to the financial sector but a low exposure to European banks. The 5.1% yield is attractive, and its expense ratio is 0.6%, which is a little high given its exposure to very liquid securities.

WisdomTree Emerging Markets Small Cap Dividend DGS
Despite its name, DGS is actually not a very risky fund. Because emerging-markets small-cap companies tend to be fairly established, the volatility of a portfolio of small-cap emerging-markets stocks has been in line with that of a broad-market portfolio of emerging-markets stocks. In addition, many emerging-markets large-cap stocks are partially government-owned, and at times, these entities put political goals ahead of profitability, which can weigh on share prices. As a small-cap fund, DGS doesn’t have these types of companies in its portfolio and instead holds mostly market-oriented firms.

Since inception, the fund has traded at slightly lower P/E ratios and delivered better risk-adjusted returns relative to a market-capweighted small-cap emerging-markets index, but we note that the fund has had a short track record. Most notably, its three-year standard deviation of 29.5% was significantly lower than the market-cap-weighted MSCI Emerging Markets Small Cap Index’s 35.3%. This may suggest that dividend-paying emerging-markets companies are higherquality firms. DGS sports a yield of 4.4% and has an expense ratio of 0.63%.

Patricia Oey is an ETF analyst at Morningstar.

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