International Affairs

If you need any more evidence that U.S. investors have fallen in love with international investing, consider these two numbers: 8,520,000,000 and negative 3,030,000,000.

That is the disparity with which investors threw money at mutual funds that invest in international stocks versus domestic stock funds in the month of June--$8.52 billion in inflows to international stock funds versus an outflow of $3.03 billion from U.S. stock funds.

And this love affair with investing abroad is hardly in the budding stage. In 2005, stock funds investing in foreign companies had net new cash of $105 billion versus $31 billion in U.S. funds. And last year, the gap widened--$148 billion in net new money for international stock funds versus just $11 billion for U.S. equity funds.

In other words, approximately 93 cents of every dollar invested in equity mutual funds in 2006 went to international funds.

The attraction of international stocks has not been confined to open-end mutual funds. Exchange traded funds investing overseas have seen their assets explode in recent years. Indeed, international ETF assets increased by more than $30 billion this year--far outpacing every other ETF category. Overall, 28 percent of the nearly $500 billion in ETF assets at the end of July was invested in 71 international ETFs.

Why have U.S. investors embraced investing abroad in such a big way? Some market watchers ascribe the increase to a wiser individual investor, one who understands the potential diversification benefits from including international investments in a broad-based portfolio. However, cynics--and count me among that bunch--have a different answer: performance. A big reason investors have piled into international investments is because that's where the returns have been. From year-end 2004 to year-end 2006, total returns on U.S. equity indices ranged from around 12 percent to about 21 percent, according to the Investment Company Institute, while returns on world stock indices (those excluding U.S. stocks) were about 45 percent. And total returns on stocks traded in emerging markets were close to 77 percent over the same period.

Rest assured, those returns have not gone unnoticed by your clients, which means on the subject of foreign investing, all advisors should have answers to the following two questions:

1) How?

2) How much?

Let's take the second question first. How much of your clients' assets should be in international investments? Now, I'm not going to give the "You-should-have-20 percent-of-your-client-assets-invested-abroad" speech. I assume you know your clients better than I do, and the one-size-fits-all approach just doesn't work well in the world of managed accounts. That's not to say that I think 20 percent is inappropriate. But 30 percent or 10 percent may be just as appropriate an allocation, depending on your client's big picture. My pitch here isn't for a specific percentage allocation. Rather, what I am emphasizing is the importance of considering the following two points when formulating an overseas investment plan for clients:

o Don't assume that diversifying your client's money internationally necessarily reduces the risk of his or her portfolio. I know conventional wisdom says that since these assets tend to be less correlated with U.S. stocks, adding foreign stocks to a portfolio reduces volatility. That may have been the case several years ago, but it appears increasingly that foreign and U.S. stock performance is joined at the hip. A number of studies--one by Geoff Considine of Quantext, Inc. is particularly interesting--examine the betas and standard deviations of foreign investments, including international ETFs. What they have found is that in some cases adding foreign investments served to amplify a portfolio's sensitivity to the U.S. market rather than provide real diversification benefits. Of course, if you look hard enough, you can find research studies to support any side of an argument, including research showing the risk-reduction effects of international investments in a portfolio. Still, it is hard to ignore the "street level" research that we have all witnessed in recent months, as we watched international markets getting pounded right alongside their U.S. counterparts. In the month of July, for example, the S&P 500 index declined 3 percent versus a nearly 5 percent decline in the NIKKEI, a nearly 4 percent decline in the FTSE 100, and a 1.5 percent decline in the MSCI EAFE. Yes, I know one month is a very short period of time. And, yes, I'm sure you can come up with international markets that bucked the U.S. market's decline (just as anyone can find U.S. stocks that rose during the market's decline). Nevertheless, it sure feels like world markets are syncing up. Bottom line: Good reasons exist for investing overseas--the expansion of your opportunity set for finding winners and the ability to take advantage of faster-growing economies than the U.S., to name two. But I would tread lightly on selling your clients the notion that more overseas means less risk.

o Investing overseas is one big currency bet. Plenty of advisors exist who would never dabble directly in the currency markets with client money. Yet, these same advisors have no problem putting 30 percent or more of client assets in international investments. The problem is that in recent years, a big chunk of the outperformance generated by overseas markets (versus U.S. benchmarks) is simply a direct result of the weak dollar. Thus, any bet you make overseas has to be framed partly as a currency bet, and a bet on the dollar remaining wounded. If that makes you a bit uncomfortable, you need to take that into account when allocating client assets overseas. At the very least you need to educate your clients about that risk.

Now, when it comes to "how" to invest overseas, let me cast a strong vote for exchange traded funds. ETFs allow an advisor to take a small amount of money and diversify it across a number of international investments. ETFs also allow you to make bets on a specific region and even on an individual country. And, yes, while international mutual funds allow you to do that as well, international ETFs have two big advantages over international mutual funds:

Fees--International mutual funds tend to be expensive. For example, according to Morningstar, the average expense ratio for diversified emerging market funds is 1.83 percent; for foreign large value, 1.40 percent; for Latin America-focused funds, 1.79 percent. Of the 71 international ETFs in the marketplace, most have expense ratios in the 0.50 percent to 0.75 percent range--on the high side relative to U.S. ETFs, but still well below the typical expense ratio of an international mutual fund. Of course an active fund manager would argue that all international ETFs are index funds, which means I'm comparing fees on index funds to fees on actively managed international funds, and that's unfair. While there may be some truth to that, I would argue that the big gap in fees between actively managed international funds and international ETFs--more than 100 basis points depending on the funds--gives international ETFs a huge leg-up when it comes to expected long-term performance.

Tradability--ETFs can be traded intraday, unlike open-end mutual funds. While I'm not in favor of trading frequently simply because you can, I do like having the increased flexibility of trading intraday with what is potentially a riskier asset class.

Of course, even if you seek international exposure via ETFs, your work is only starting. You need to know what ETF to choose, how it differs from other ETFs, and what are some things that could come back to bite you. Here is a short checklist of factors to consider:

o Taxes: ETFs are reasonably tax-friendly investments. However, international ETFs are some of the least friendly when it comes to taxes. The table above lists a number of foreign ETFs and shows how their distributions were taxed in 2006. Notice that in some cases, 50 percent or more of fund distributions were not classified as "qualified," meaning they did not receive favorable tax treatment. Several issues are responsible. One is a quirk in the tax system that can play havoc with single-country funds. Securities laws state that ETFs lose their right to pass-through capital gains to shareholders if the ETF has more than 25 percent of its assets in the securities of any one issue at the end of a fiscal quarter. ETFs with such a large exposure may be forced to sell down certain holdings to below the 25 percent level, thus creating potential capital gains for ETF holdings. And as sometimes occurs, these capital gains are short term; they are ineligible for favorable tax treatment. When investing in international ETFs--especially in single-country funds--it becomes necessary, therefore, to check portfolio concentrations to avoid buying into a potential tax headache.

o Diversification: The top three holdings in the iShares MSCI Belgium Index Fund (EWK)--Fortis, KBC Groep and Dexia--account for nearly 49 percent of the entire fund; in the iShares MSCI Sweden Index Fund (EWD), Ericsson accounts for 16 percent; and in the iShares MSCI Mexico Index Fund (EWW), America Movil accounts for more than 25 percent of the fund. In short, these funds are more like individual stock bets than diversified portfolios. While there is nothing inherently wrong with such concentrations, they will impact the ETF's volatility.

o Tracking error: International ETFs, especially emerging country ETFs, may experience higher than expected tracking error versus their underlying indices due to the liquidity of the stocks in the index, higher expense ratios and ETF construction--i.e. exact replication of the underlying index versus a sampling approach.

o Index construction: The WisdomTree Emerging Markets High-Yielding Equity Fund (DEM) and the Vanguard Emerging Markets Stock Fund (VWO) both invest in emerging markets, but do so in very different ways. As the name implies, the WisdomTree ETF focuses on dividend-paying stocks and weights its components based on annual cash dividends. On the other hand, the Vanguard Emerging Markets ETF tracks the MSCI Emerging Markets Index, a capitalization-weighted index that does not include dividends as a criterion for inclusion. The upshot is that both ETFs are "emerging market funds," but returns may vary significantly, depending on market conditions. How the underlying index is constructed and weighted is an important factor to consider when choosing international ETFs.

o Me-Too ETFs: With the proliferation of international ETFs will come more "me-too" ETFs that track the same or similar international indices. For example, the iShares MSCI Emerging Markets (EEM) and the Vanguard Emerging Markets both track the MSCI Emerging Markets Index. Yet, the annual expense ratio on the Vanguard ETF is 0.30 percent versus 0.75 percent for the iShares ETF. All things equal, you'll want to invest in the one with the lowest expenses.

Chuck Carlson, CFA, is chief executive officer of Horizon Investment Services and the author of Winning With The Dow's Losers (HarperBusiness). David Wright, CFA, provided research assistance for this article.