Global Fund Design With ETFsJohn H. Christy, Forbes International Investment Report, 03.27.09, 06:00 PM EST
International funds aren't always a great fit off the rack. Try a custom-tailored approach instead.
Investment funds are a bit like suits. Some fit just fine off the rack, others need a few alterations. Unfortunately, you can't call your mutual fund manager and ask him to make a few changes to the fund's portfolio to suit your tastes. But you can do the next best thing: use exchange-traded funds as building blocks to create a customized portfolio of your own design.
International ETFs are especially interesting in this respect. It wasn't long ago that countries like Turkey, Chile or Malaysia were essentially off limits to small investors. But these days, the Barclays iShares family of ETFs offers access to these countries and more than two dozen other international choices. Even more flavors are available from other ETF purveyors, such as Invesco PowerShares and WisdomTree.
Want to go long South Africa and short Thailand? You no longer need a private jet or a team of analysts roaming the globe, like Templeton's Mark Mobius. A laptop with an Internet connection will do just fine.
While the range of options on the international investing menu has expanded exponentially in recent years, most investors aren't taking full advantage of these new tools. In my experience, when it comes to international investing most folks tend to do one of two things.
The first--and the worst--approach is to chase the hottest markets. When everyone's talking about China, they buy a China fund. When India becomes the next big thing, they buy the latest India ETF being touted on CNBC. And at the first sign of trouble, they stampede for the exits. This method virtually guarantees lousy performance.
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A second approach is to simply choose the "default setting" for international exposure: EAFE. Maintained by MSCI Barra, the EAFE index is the Dow Jones of foreign stocks. For better or for worse, it's the benchmark that has become virtually synonymous with "international" investing.
One of the most popular international ETFs, iShares MSCI EAFE (nyse: EFA), has $32 billion of assets under management. Since EAFE is a common performance benchmark, many actively managed international equity mutual funds are substantially similar to EAFE, despite what their marketing literature says.
EAFE's history dates back to the early 1970s, when American institutions discovered that stock markets existed beyond U.S. shores. Today, the index covers more than 1,000 stocks in 21 countries. Yet EAFE retains some hints of its disco-era past.
The top five countries in EAFE--which collectively represent more than 70% of the index--are Japan (25%), the U.K. (20%), France (11%), Germany (9%) and Switzerland (8%). There was a time when investing in British and French stocks was considered pretty exotic. But there was also a time when John Travolta's white suit in Saturday Night Fever was cutting-edge fashion.
Don't get me wrong. If you're bullish on these five countries, EAFE is a perfect fit. But I'm not sure most investors understand some of the lopsided allocations in the EAFE index. There are a lot of great companies in Japan and the U.K., but do you really want 45% of your international investments concentrated in those two countries?
By design, EAFE also ignores emerging markets. For example, none of the BRIC (Brazil, Russia, India, China) countries are represented. The sum total of EAFE's non-Japanese Asian exposure is a scant 3% in Hong Kong and Singapore. That's the same amount allocated to Italian stocks.
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I don't have a crystal ball, but I'm pretty darn sure China will be a better bet than Italy over the next decade or two. Is Belgium a better bet than Brazil? I don't think so, but that's what EAFE implies by allocating 0.75% to Belgium and a goose egg to Brazil. I'll take the moules frites and a cold Stella Artois, but you can keep the Belgian ETF.
This isn't just index fund trivia. Ignoring smaller markets can have a big impact on performance, because the world's best-performing markets are often found off the beaten path. While most markets in the developed world are in the red over the past 10 years, smaller markets like Chile, South Africa and Malaysia have delivered robust annualized returns of more than 7%. Others, like the Czech Republic and Colombia, are well into the double digits, despite last year's bloodbath. If you relied solely on EAFE to capture these returns, you'd be disappointed.
Instead, you can build your own international fund by picking a handful of countries or geographic regions and weight them according to your level of conviction rather than market cap or gross domestic product.
But don't get carried away. Your tailor can probably make you a lime green zoot suit, but it's not going to be appropriate for most occasions. Likewise, you could theoretically create your own international ETF fund composed of 40% in Turkey, 35% in Malaysia, 15% in Sweden and 10% in Belgium, but that would look a bit strange too.
A better approach is to supplement a core holding in an EAFE fund with a few targeted investments in countries or regions that you'd like more exposure to. Another approach: Take the iShares MSCI Emerging Markets Fund (nyse: EEM) and balance it out with a handful of developed market country funds.
If you have no clue what you're doing--or couldn't care less--an EAFE fund is still probably your best bet. But if you have a strong investment view on a particular country or region, don't be afraid to use ETFs to build your own international fund.