The addition of international exposure to a portfolio is supposed to decrease its volatility while adding alpha over time. Historically, as U.S. markets retreat European, Asian and Far East (EAFE) markets tend to rise. Recent history has proved the opposite to be true, however. Assets that once moved in opposite directions have begun to rise and fall in unison.

The cause of this anomaly can be traced back to the credit crisis in the U.S. mixed with global fears of inflation, and U.S. companies increased exposure to revenues from overseas markets. Investors relying solely on EAFE Indexes as a counter to the S&P 500 may consider adding a safety in the form of a short-focused ETFs (inverse ETFs) or extend their investment horizon.

Recent Returns
The iShares MSCI EAFE ETF (AMEX:EFA) is down nearly -19% since the beginning of the year while the S&P 500 is down just over -17%. In order to counter this short term correlation an investor would need to hold the Short MSCI EAFE ProShares (AMEX:EFZ), which increases in value when the MSCI EAFE Index falls. The EFZ ETF returned nearly 16% during the same time period. Since we're not short term investors lets take a closer look at the recent problems of a few EAFE economies and how the EAFE index has performed over a longer period of time. (For more on this type of exchange traded fund, read our related article Inverse ETFs Can Lift A Falling Portfolio.)

EAFE Insight
The EFA ETF is very well diversified over its 817 holdings. At the end of June more than 50% of its holdings are derived from Japan, the U.K. and France. Familiar names among its top 10 holdings include Toyota Motors (NYSE:TM) of Japan, Nestle of Switzerland, and HSBC Holdings (NYSE:HBC) of the U.K.

  • Japan - Japan is going through economic difficulties of its own in the form of rising unemployment and stricter spending habits from consumers who have not been immune to rising energy and food prices. Fewer disposable dollars for U.S. consumers also limit the revenue of Japan's automobile and electronic manufactures.

  • The U.K. - An economic slowdown in the U.K. has been tied to declining sales in real estate and overall business activity. The economy grew by only 0.2% for the second quarter, the slowest rate for the country since 2001.

  • France - The French economy is also expected to expand at its slowest rate in the past five years at 1.6%. Inflation in the form of rising energy and food prices along with slowing real estate sales have also help to slow the economy.

Going International Still Worth It?
The benefit of holding the EFA ETF is easily seen once we extend our holding period. Over the past three years the EFA ETF is up over 21% while the S&P 500 is down just under 1%. The S&P 500 index can be tracked in a portfolio by holding the SPDRs ETF (AMEX:SPY).

International exposure is a must for any portfolio with an extended period of time to recover from short term pullbacks. It's also good to know that investors with shorter time horizons can buy some protection by focusing on ETFs that rise when international indexes fall.

To learn more, read Go International With Foreign Index Funds.

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