Go International With Foreign Index Funds

By Hans Wagner AAA

International markets, through 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. Read on to explore an approach to the international markets and discover some investing options to increase growth and diversity.

SEE: Introduction To Exchange-Traded Funds

Indexes and Economies
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 tenth largest economy, according to the IMF, 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 continue to experience rapid growth and are considered emerging, as opposed to the mature economies of the U.S. and EAFE. Finally, there are the remaining emerging economies consisting of much of the rest of the world.

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There are a number of other indexes that include combinations of these countries, such as the MSCI EMU (European Economic and Monetary Union) IndexSM, a free float-adjusted market capitalization index that is designed to measure equity market performance within the EMU. As of June 2012, the MSCI EMU Index consisted of 10 developed market country indexes: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands and Spain. Additionally, there is also the MSCI Emerging Markets Index, which as of June 2012, includes China, South Korea, Brazil, Taiwan, South Africa, India, Russia, Mexico, Malaysia and Indonesia.

New indexes such as these are being created to help expose investors to new segments of the global market.

Ways to Invest
Some of the best ways to invest in foreign markets are exchange traded funds (ETFs) that track foreign indexes. Other options are global companies that have significant operations in the region or country of interest and individual foreign stocks that have established tradable securities like the American depositary receipts.

SEE: American Depositary Receipts

ETFs

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 would buy a stock. However, investors must still 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.

SEE: Finding Fortune In Foreign-Stock ETFs

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 may think he or she is participating in all the public companies in Mexico. It turns out EWW is dominated by a few stocks - As of June 2012, America Movil, Walmart, Cemex, and Femsa make up close to 46.6% of the total capitalized weighted fund. Also, 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 around 20% 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.

SEE: Analyzing A Bank's Financial Statements

Big Companies for Wide Exposure

Another way to invest in foreign markets is through global companies that have significant operations in the region, country or sector of interest. These companies may give you exposure to growth opportunities without having to take on the risk that comes with many of the emerging markets

For example, Johnson & Johnson is a global company that makes a large portion of its sales outside of the U.S. An investment in JNJ gives an investor exposure to global markets, while counting on the company's management to address the higher risks that come from these markets. Buying a company like JNJ provides some global exposure, but if no country outside of the U.S. represents more than 10% of a company's net revenue, they are not required to disclose what countries and regions are driving this revenue. As a result, you may not know which countries are included in your portfolio.

ADRs

American depository receipts (ADRs) offer another way for investors to gain foreign investment exposure. ADRs give foreign companies access to U.S. financial markets and they give investors using U.S. exchanges an easy way to gain exposure to foreign companies. According to the Bank of New York, companies that have ADRs usually have better disclosure than foreign companies that do not have ADRs. Since ADRs trade just like U.S. securities, they are a low cost way to invest in foreign countries or regions without having to invest through foreign stock markets.

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 markets provides 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.

Currency Fluctuations

Despite their advantages, foreign stocks also carry many of the usual risks that accompany investment. For example, as foreign currencies become stronger or weaker than your local currency, your return will vary accordingly. If the rates go your way, your returns will increase. If they go against you, it decreases your return.

SEE: Commodity Prices And Currency Movements

Political Risk
The political stability of the country's government can have a significant impact on the value of your investment. Governments may pass laws that 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. And, high inflation can harm your investment.

Over-Concentration

While investing in foreign indexes can help you to diversify your portfolio, it can also cause you to concentrate in one sector (or country if one is investing in a region). Also, a number of the foreign indexes are capitalization-weighted, meaning that a disproportionate amount of their capital may be concentrated in a few countries or stocks

High Expense Ratios
Another consideration is that foreign ETFs aren't inexpensive investments. 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 20 cents 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 72 cents, 52 cents and 59 cents per $100 invested. That's still inexpensive in absolute terms, but it's truly expensive for funds with portfolios that are essentially assembled by a computer. With an MER of 0.74% for example, 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.

According to a 2006 study by Quantext, most international ETFs have a beta greater than 1 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. 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 an investor's preferred levels.

Do Your Homework
When considering foreign investment opportunities, an investor should do his or her homework. You need to understand the economic environment and business fundamentals. Understanding any political risks at play is also important to your analysis.

Be sure to recognize that investing in foreign markets changes your total portfolio's diversification and risk profile. In addition, 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.

The Bottom Line
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.

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