International Exposure Through Investments in Foreign Index Funds
Stock-Markets / Investing Feb 13, 2007 - 02:32 AMBy: Hans_Wagner
International markets, through their index funds, offer excellent investment opportunities with parallel risks. Investors can gain appropriate exposure to these opportunities while mitigating the risks through several viable investment options. The purpose of this article is to explore how to approach the international markets and offer some investing options to increase growth and diversity.
Basically, there are three categories of foreign index funds. The EAFE (Europe, Australasia & Far East) is a widely followed index. For some reason Canada, the world's 9 th largest economy, is left out of this index, as well as the U.S. based indexes. Next, are the BRIC countries of Brazil, Russia, India and China. These economies are experiencing rapid growth and are considered emerging rather than the mature economies of the U.S. and EAFE. Finally, there are the remaining emerging economies of much of the rest of the world.
EAFE |
BRIC |
Emerging Markets |
|
Description |
The developed economies of Europe, Australasia & the Far East. The economies are similar in character to the U.S., some with slower growth. Stable political governments. |
The large and rapidly developing economies of Brazil, Russia, India, and China. These economies are becoming significant forces in the world economy. Considered stable political governments |
Developing economies worldwide. Economies different from U.S., some experiencing rapid growth, others highly dependent on a few large companies and many small businesses. Some political instability in governments may exist. |
Countries |
Australia |
Brazil |
Argentina |
Sectors |
Consumer Discretionary |
Banks |
Banks |
There are a number of other indexes that include combinations of these countries such as the MSCI EMU (European Economic and Monetary Union) Index SM , a free float-adjusted market capitalization index that is designed to measure equity market performance within the EMU. As of June 2006 the MSCI EMU Index consisted of 11 developed market country indices: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Portugal and Spain.
As of June 2006 the MSCI Emerging Markets Index consisted of 25 emerging market country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.
New indexes are being created to help investors interested in the new segments of the global market.
Exchange Traded Funds
Some of the best ways to invest in foreign markets are Exchange Traded Funds (ETFs) that track foreign indexes. An ETF of a foreign index is a basket of stocks that are included in the index. With these ETFs, investors have easy access to foreign markets. All they have to do is buy the ETF just like they buy a stock. However, they still must do their homework. Like any stock, it is important to understand the characteristics that comprise the index. In the case of a foreign ETF, you may be surprised at the underlying stocks that make up the index.
For example, the iShares MSCI Mexico Index Fund (EWW) seeks to provide investment results that correspond generally to the price and yield performance, before fees and expenses, of publicly traded securities in the Mexican market. An unwary investor might think they are participating in all the public companies in Mexico. It turns out EWW is dominated by two stocks: American Movil and Cemex make up close to 40% of the total capitalized weighted fund. Also, both of these companies are traded on the New York Stock Exchange (NYSE) through their ADRs.
In another case, let's say you wanted to get more exposure to the Pacific Rim, but not necessarily Japan. There is an ETF called the iShares MSCI Pacific ex-Japan Index Fund that seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of publicly traded securities in the Australia, Hong Kong, New Zealand and Singapore markets, as represented by the MSCI Pacific Free ex-Japan Index. You would need to know that 23% of the fund is comprised of commercial banks. If you already held some banks in your portfolio, then you might not be getting the diversity you expected.
ETFs provide the best alternative to gain access to emerging markets, as they are easy to understand. However, global companies and ADRs are viable options.
Benefits and Risks
Investing in foreign offer markets offers you the opportunity to participate in exceptional gains from rapidly growing economies. It also gives investors an additional way to diversify their portfolios. Finally, investing in foreign markets offers investors a way to participate in the commodity driven economies that are significant participants in these emerging markets. Likely, there is an index and ETF that will meet your needs.
Foreign stocks also carry many of the usual risks that must be understood before making a commitment. As foreign currencies become stronger or weaker than your local currency, your return will vary accordingly. If the rates go your way, it increases your return. If they go against you, it decreases your return.
The political stability of the country's government can have a significant impact on the value of your investment. Governments may pass laws that can significantly harm the value of your investment, such as nationalizing an industry. Also, many countries may experience higher inflation as their economies do not have the necessary economic controls in place to deal with the causes of inflation. High inflation can harm you investment.
While investing in foreign indexes can help you to diversify your portfolio, it can also cause you to concentrate in one of a few sectors, or country if one is investing in a region. Also, a number of the foreign indexes are capitalization-weighted, giving them a disproportionate amount of their capital concentrated in a few countries or stocks.
Another consideration is that foreign ETFs aren't all that cheap. It turns out the cost advantage of many U.S. based ETFs is not the same as for emerging markets. Many U.S. ETFs have an expense ratio of $0.20 per $100 invested, while the iShares FTSE/Xinhua China 25 (FXI), iShares Brazil Index Fund (EWZ) and South Africa (EZA) all have expense ratios of $0.74 per $100 invested. That's still inexpensive in absolute terms, but it's expensive for funds with portfolios that are essentially assembled by a computer. A $100,000 investment in such a fund would cost about $24,000 in fees over 15 years, assuming 10% yearly returns. With higher returns, your fees will be even higher.
Investments with high Betas serve as a warning that the portfolio may have higher risk than desired. The portfolio may also experience volatility that exceeds their preferred levels.
According to a study by Quantext, most international ETFs have a Beta greater than 100% and almost all of them have a standard deviation of annual return that is dramatically higher than the volatility (the standard deviation in annual return) projected for the S&P 500. Based on historical volatility and Betas, many of these foreign ETFs look more like aggressive growth investments. As a result they may not be the best alternative to help manage portfolio risk.
Do Your Homework
When considering foreign investment opportunities, an investor should do their homework just like any other investment. You need to understand the economic environment and business fundamentals. Further, understanding the political situation is also important to your analysis.
Also, be sure to recognize that investing in foreign markets changes your total portfolio's diversification and risk profile. And just like your domestic investments, set appropriate targets along with stops to protect your capital. Keep in mind that many are capitalization-weighted, causing many ETFs to have a disproportionate amount of their capital in a few sectors or countries.
MSN Money is a good source for information on ETFs, including foreign index funds. The Exchange-Traded Funds Manual.
Doing you homework will give you an edge when investing in international markets. Spend the time necessary to give you a clear picture of the opportunity and risks, and how it will compliment your existing portfolio.
Conclusion
Investing in foreign markets can offer greater rewards along with greater risks. To be successful you need to do your homework, researching the alternatives before making a commitment of your hard earned capital. As global trade continues to expand and the world's economies grow, investors will have new and exciting opportunities to generate wealth. They also must be cognizant of the risks and take appropriate action to protect their capital. As always, it is most important to do the necessary research before making an investment decision.
by Hans Wagner
tradingonlinemarkets.com
My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/
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