Diversification: How to Get Broad Exposure Overseas

    by Albert J. Fredman

    Diversification: How To Get Broad Exposure Overseas Splash image

    Mutual funds that invest in foreign equities have disappointed U.S. investors for years. Since the early 1990s, the strong dollar has been a major drag on foreign returns.

    The United States established itself as the world’s premier equity market during the past decade and I expect it will maintain that status. Nevertheless, in my October 2001 AAII Journal column (“International Investing: It Still Makes Sense to Diversify,” available at www.aaii.com) I explained why moderate foreign equity exposure is an important dimension of a well-diversified portfolio. Essentially, it insures against a decline in the U.S. dollar and may protect against an extended period of poor domestic equity performance.

    Meanwhile, overseas markets have become better places to invest, as foreign economies continue to move more toward a U.S.-style model. Companies are being privatized, costs are being cut, and financial reporting is becoming more transparent. In addition, the recently expanded coverage provided by the Morgan Stanley Capital International (MSCI) EAFE (Europe, Australasia, Far East) index is good news for index fund investors.

    A Weakening Dollar

    The U.S. dollar has appreciated substantially since the mid-1990s, as overseas money cascaded into the highly attractive U.S. economy, thereby increasing demand for the greenback. This, in turn, added fuel to the escalating bull market. Recently, with slowing inflows of foreign capital, the dollar has begun to slide against the euro and the Japanese yen as well as other major currencies. The dollar is highly sensitive to foreign capital flows these days. A fading attraction to the dollar would make any rebound in the U.S. equity market more difficult to achieve.

    Overseas investors who sent their money to the U.S. benefited from a rising dollar over the past seven years as well as from soaring stock prices. Conversely, a declining dollar now makes non-U.S. investments more attractive to dollar-based investors who benefit from appreciating foreign currencies, making it possible to convert their investment gains into more and more dollars. Several factors account for the dollar’s recent slide, including reduced buying of U.S. securities by overseas investors due to poor equity performance over the past two years. In fact, we may even experience three consecutive years of stock market losses—something not seen in the S&P 500 since 1939—41. Other parts of the world have become relatively more attractive to global money managers. Asian and European equities offer lower valuations than are generally available on comparable U.S. equities.

    That said, there are no guarantees that the dollar will continue to weaken or that foreign markets will continue to outperform ours as they have recently.

    The bottom line is that currency and stock market trends are extremely difficult to predict, particularly in the short run.

    Comparative Performance

    Table 1 illustrates that foreign markets were off to a strong start in 2002 (through May 31), while the U.S. market declined 6.49%—as represented by the S&P 500. The five MSCI indexes provide a broad overview of non-U.S. equity market performance. The MSCI EAFE index, up 2.46% this year, is the broadest measure, as it covers all the world’s developed equity markets—excluding those in the Americas.

    The MSCI Japan index has gained an impressive 14.22% in U.S. dollars year to date. Its 8.16% return in local currency reflects the fact that a large portion of the gain realized on Japanese equities this year by U.S. investors has been due to an appreciating yen.

    Emerging markets fared well in last year’s fourth quarter and year to date, fueled by expectations that those economies will benefit from the U.S. economic recovery and from China’s growth. Experts view emerging markets as a leveraged play on the recovering global economy.

    TABLE 1. Performance of Major World Indexes in U.S. Dollars
    Benchmark   Annualized Returns (%)
    Recent Performance (%) 5
    2001 Quarter Ended
    12/31/2001 9/30/2001
    MSCI EAFE Index 2.46 6.97 -14.00 0.89 4.46
    MSCI Pacific Free Index 12.38 -0.64 -18.29 -7.96 -2.46
    MSCI Europe Index -1.17 12.71 -15.46 7.73 10.13
    MSCI Japan Index 14.22 -5.93 -18.13 -7.91 -3.78
    MSCI Emerging Markets Free 10.34 26.6 -21.60 -5.74 3.05
    S&P 500 Index -6.49 10.69 -14.67 10.7 12.93

    Table 1 also shows how the five MSCI benchmarks have fared relative to the S&P 500 during the past five and 10 years.

    Japan’s poor stock market performance since 1990 stands out by itself and it also had a major impact on the Pacific Free Index because of its dominant weighting, which recently stood at 75%. Japan also recently had a 21% weight in the broader MSCI EAFE. Japan’s annualized —3.78% water-torture return over the decade ended December 2001 stands in sharp contrast to the S&P 500’s 12.93% yearly gain. For the 20 years ended December 2001, the annualized returns for the EAFE, Japan, and S&P 500 indexes were 11.02%, 7.05%, and 15.20%, respectively.

    Thus, the Japanese market has had a significant impact on the long-run underperformance of foreign equities, particularly for those foreign-stock funds—including indexed portfolios—that have consistently maintained a hefty stake in that market. But this could all change going forward as Japan now constitutes a much less significant weight in the EAFE and that market may perform better on a relative basis over the next decade.

    Foreign Stock Funds

    Foreign stock funds (aka international funds) invest primarily in a wide assortment of non-U.S. markets, and are recommended to individuals looking for one-stop international diversification. As an aside, you might want to avoid global stock funds, which typically hold both U.S. and foreign stocks. The domestic proportion can vary from less than 20% to more than half. Further, the manager can vary the mix, affecting your own asset allocation of U.S. stocks relative to foreign holdings. The ability of global funds to amass large U.S. holdings is, in my view, a drawback. That’s why I’m partial to foreign stock funds.

    Artisan International, Fidelity Diversified International, Harbor International, T. Rowe Price International Stock, and Vanguard International Growth are examples of broadly diversified foreign stock funds. Profiles of these and other foreign equity funds are found in The Individual Investor’s Guide to the Top Mutual Funds, published by AAII.

    It is important to check the percentage of assets allocated to individual countries with these portfolios. For instance, during the 1980s, most funds with a dominant stake in Japan did phenomenally well. The Nikkei index hit an all-time high of 38,916 at the end of 1989. But then the bubble burst and the index headed straight south and now trades at less than a third of its former high. (It touched a low of 9,421 last year and even dipped below the level of the Dow industrials earlier this year). Consequently, foreign stock funds that maintained a sizable stake in Japan have generally lagged. This is particularly true of EAFE-based index funds since they need to stick with index weights.

    A foreign stock fund’s positioning in out-of-favor countries often reflects the manager’s ability to think independently. This is a desirable trait often seen in the most successful stock pickers, especially in the international realm, which offers more opportunities to be creative and add value. Therefore, if your foreign stock fund has overweighted countries that its peers have underweighted or avoided, that’s not necessarily a cause for alarm. Still, you can never be sure that the manager is right.

    Indexing Internationally

    Returns, risk, and costs are the three most important variables to ponder when evaluating any investment. I explained and illustrated how compounding costs erode wealth in my May 2002 AAII Journal column (“Fund Investors’ Biggest Mistakes and How You Can Avoid Them,” found on AAII.com). Gross returns are very difficult to predict, but risk can be managed and costs can be minimized.

    For international investors, I suggest managing risk by investing in a widely diversified foreign stock fund and allocating no more to non-U.S. markets than you are comfortable with. Going with the lowest cost foreign-stock index funds easily minimizes costs. For starters, the average expense ratio for foreign stock funds is 1.65%, versus 1.43% for the average U.S. diversified equity fund, according to Morningstar (although you can find some managed foreign stock funds with expense ratios of 1%, or less). Conversely, the broadly diversified Vanguard Total International Stock Index has a 0.35% expense ratio. Fidelity Spartan International Index, which tracks the EAFE, has a 0.35% capped expense ratio.

    Foreign stock funds do not turn their portfolios over quite as rapidly as their U.S. diversified equity counterparts—the category averages are 87% versus 109%, according to Morningstar. Transaction costs, however, are significantly higher in overseas markets. Further, an 87% turnover rate is high in an absolute sense and the higher transaction costs associated with that number take a significant bite out of returns.

    Conversely, the Vanguard European and Pacific stock index funds recently had turnover rates of only 3% and 2%, respectively. Fidelity Spartan International Index had a 12% turnover rate.

    TABLE 2. Active Managers Outperformed by Benchmarks
      Comparison Periods*
    3 Yrs
    5 Yrs
    10 Yrs
    European funds outperformed by MSCI Europe Index 38 69 60
    Pacific funds outperformed by MSCI Pacific Index 16 47 9
    International funds outperformed by MSCI EAFE Index 32 41 31
    Large-cap U.S. funds outperformed by S&P 500 47 73 77
    U.S. diversified equity funds outperformed by Wilshire 5000 33 54 59

    With the exception of the European market, active management appears to have had a performance edge in foreign markets over the past decade. Table 2 displays the percentages of managed funds within several fund categories that were outperformed by their respective benchmarks. Note the striking contrast between Europe and Pacific portfolios over the past 10 years: MSCI Europe outperformed 60% of European funds, whereas MSCI Pacific outperformed only 9% of Pacific funds.

    Critics of indexing internationally point out that a passive EAFE portfolio locks an investor into that benchmark’s country weightings. Investors may want to underweight or avoid troubled markets or regions, and overweight the more promising ones. Many investors select an actively managed foreign stock fund and leave these decisions to the manager. However, there are no guarantees that the manager will succeed in timing markets. Some investors tend to forget that a fund manager’s performance is not very predictable, and instead go after the hot fund performers. Doing so is at least as dangerous with foreign-stock funds as it is with domestic equity funds.

    Because of their big-cap bias, most index funds don’t provide the kind of exposure to smaller companies needed to achieve the most beneficial non-U.S. diversification. That’s because large multinationals don’t offer as high a degree of diversification as smaller companies, whose profits are driven more by the health of the local economy. Those seeking greater diversification might add a small-cap foreign stock fund to their holding in an EAFE index fund.

    That said, the MSCI EAFE promises to be a better index going forward due to important recent changes. It may be a more difficult benchmark for active managers to beat because it now more closely reflects the opportunity set of stocks available to active investors. Comparing a manager’s performance against a benchmark is only meaningful when the index reflects the highest possible proportion of the opportunity set available.

    A Better EAFE

    As of the end of May 2002, the EAFE had expanded its coverage in each country to 85% of float-adjusted market capitalization, up significantly from the former 60% of total market capitalization. With float-adjusted market capitalization, free float rather than total shares outstanding is used in calcualting index values. Free float represents the shares of a company that are outstanding and available for public trading; it excludes shares such as those held by corporate insiders and governments and shares that are subject to foreign ownership restrictions.

    Because the EAFE is now float-adjusted, it more accurately reflects the quantity of stock in individual companies that investors can purchase. For instance, a company with a large total market cap could have a small float if insiders tightly hold a large percentage of its total shares.

    Thus, with its expanded and more realistic coverage, the EAFE will be a harder hurdle for active managers to beat. Most importantly, they have fewer opportunities outside the benchmark to find stocks that may outperform. The variability of active manager’s returns around the index return should decrease.

    Exchange-Traded Funds

    A major fund innovation, exchange-traded funds are typically index-based equity portfolios that trade as a stock. However, unlike closed-end funds, they don’t go to substantial discounts and premiums. Rather, their stock prices tend to hover around the fund’s net asset value. Such funds have proven highly popular in the domestic fund arena, particularly for tracking broad benchmarks like the S&P 500. The iShares may be more tax-efficient than their otherwise equivalent mutual funds because exchange-traded funds have ways of minimizing capital gains distributions as they are not structured to allow cash redemptions.

    Single-country funds: Most foreign equity exchange-traded funds focus on one country’s stock market. Such funds are generally too narrowly focused for most investors. It may be tempting, for example, to invest heavily in a fund targeting the South Korean stock market because that market performed so well after hitting bottom in September 2001. But red-hot markets can plunge even more quickly than they soar. Trying to pinpoint which nation’s market is going to surge next is akin to searching for that elusive stock that’s poised to soar. Is it going to be Belgium, Italy, Japan, Mexico, South Korea, Switzerland or Taiwan? Remember that overconfidence is a major psychological hang up of individual investors. Overconfident investors often place bets that are too large and trade excessively. Volatile single-country funds are just another tempting wild-card play for such individuals, who may end up with mediocre results, or worse.

    TABLE 3. Multi-Country Exchange-Traded Funds*
    Fund (Amex Ticker Symbol) Total Net
    ($ Millions)
    Largest Country Weightings
    (% of Assets)
    iShares MSCI EAFE (EFA) 3,944.20 0.35 U.K. (27.6), Japan (19.9), France (9.7), Switzerland (7.9), Germany (7.2)
    iShares MSCI EMU (EZU) 104.9 0.84 France (27.6), Germany (20.9), Netherlands (17.5), Italy (10.9), Spain (9.1)
    iShares S&P Europe 350 (IEV) 610 0.6 U.K. (39.6), France (13.7), Germany (10.2), Switzerland (10.0), Netherlands (7.9)
    iShares MSCI Pacific ex-Japan (EPP) 88.4 0.5 Australia (60.3), Hong Kong (25.7), Singapore (12.0),New Zealand (2.0)
    IShares S&P Latin America 40 (ILF) 11.4 0.5 Mexico (56.8), Brazil (38.7), Chile (1.8), Argentina (1.5)

    However, a few cases might be made for a disciplined investor taking a modest position in a single-country fund. Japan is one since it is the world’s second largest stock market and its performance has exhibited a low correlation with that of the U.S. market (as evident in Table 1). Naturally, there are no guarantees that the market will enjoy a sustained recovery anytime soon. Japan experienced large bear-market rallies in both 1995—96 and in 1998—99.

    An index fund offers a good way to allocate a small slice of your stock portfolio to the Japanese market. The broad-based $722 million iShares MSCI Japan Index (EWJ) and the newer, somewhat more focused $35 million iShares S&P/Topix 150 Index (ITF), offer separate ways to index the Japanese market. The former holds 284 stocks, the latter 151. Expense ratios are 0.84% and 0.50%, respectively. However, most investors who hold a broadly diversified international fund or an EAFE index fund probably already have ample exposure to Japan.

    Multi-country funds: Several multi-country exchange-traded foreign stock funds now exist (Table 3). I have not included the multi-country iShares S&P Global 100 Index because it has about 61% of its assets invested in the U.S.

    The iShares MSCI Pacific ex-Japan Index and iShares S&P Latin America 40 Index are both heavily weighted toward their two largest country holdings, making them almost as risky as single-country funds. The lowest cost and broadest diversification of the multi-country, exchange-traded funds is provided by the $3.9 billion iShares MSCI EAFE Index. This 784-stock portfolio is by far the largest of the international exchange-traded funds—a reflection of its popularity.

    Index Mutual Funds

    A regular EAFE index mutual fund may be a better choice from a transaction cost standpoint if you plan to add money to your investment on a regular basis. Fund of funds Vanguard Developed Markets Index and Fidelity Spartan International are other low cost, EAFE-tracking choices. For the broadest foreign stock exposure, check out Vanguard Total International Stock Index, a fund investing in Vanguard’s European, Pacific and Emerging Markets stock index funds. This $8 billion portfolio provides a 9% stake in emerging markets in addition to its 91% EAFE allocation. Some investors may want to decide personally on their allocation between developed and developing markets by pairing up an EAFE index fund with an emerging markets index fund.

    The $1.1 billion, 498-stock Vanguard Emerging Markets Stock Index offers pure exposure to the world’s most liquid developing markets based on a customized index. Its top five country weightings are Mexico (17.0% of assets), Korea (16.9%), South Africa (15.6%), Brazil (15.2%), and Greece (8.3%). From the fund’s May 1994 inception through April 2002 it returned +1.1% yearly, beating its benchmark’s —0.2% return as well as its managed counterpart’s, —0.6% return. Vanguard Emerging Markets was up 61.6% during its best year (1999), contrasted with a 27.6% slide during its worst year (2000). For the five months ended May 31, 2002, the portfolio was up 10.27%. The fund has a 0.6% expense ratio, well below half the average expenses of its managed peers.

    Going Global

    International diversification makes sense for today’s investors who have multi-decade time horizons. Keep these guidelines in mind should you decide to spread a modest portion of your money around the globe:

    • Determine your long-run allocations. Decide how you want to apportion your stock fund holdings among U.S. and foreign markets, including both developed and emerging ones. As a general guideline, target 10% to 20% of your total stock allocation to non-U.S. equity funds, depending upon your time horizon and risk tolerance. Remember that if you hold an S&P 500 or Wilshire index fund, you are already getting moderate exposure to foreign equities through large multinational companies. And actively managed domestic-equity funds often have some foreign holdings.

    • Spread your money around. Avoid the temptation to speculate on a hot market. In addition, make sure you don’t end up with too much exposure to developing markets, small foreign stocks, or a particular region of the globe. Diversified foreign stock funds with good long-term records and low cost MSCI EAFE or other broad-based foreign stock index funds make excellent portfolio anchors.

    • Avoid high-cost funds. Because foreign investing is more costly in general, it’s easy to overpay. In addition to favoring funds with low expense ratios, look for low turnover rates. A stock’s price can be unfavorably impacted by a manager’s own actions when he needs to buy or sell quickly—particularly in less liquid markets.

    • Avoid currency hedgers. Currency fluctuations are extremely difficult to predict. Funds that do little or no currency hedging enjoy a built-in cost advantage. Importantly, you gain exposure to other currencies that can act as a further diversifier. Low-cost index funds—including index-based exchange-traded funds—are ideal for your foreign allocation because they do not hedge currencies.

    • EAFE indexing looks more promising. Foreign stock index funds may do better going forward because Japan is now a smaller slice of the EAFE and it could rebound. More importantly, you can expect low cost EAFE index funds to perform better relative to active managers than they have in the past due to the recently expanded and float-adjusted coverage of the EAFE benchmark.
    Overseas markets have performed well year-to-date relative to the S&P 500, and high-profile world currencies have begun to appreciate in value relative to the U.S. dollar. But there are no guarantees that these enticing trends will continue. The world is too complex and risky for us to be able to predict stock markets and currencies with confidence.

    Yet there is a chance that foreign markets could perform favorably relative to the S&P 500 long term because of their generally more attractive valuations in mid-2002.

    The lesson of both the tech crash and September 11 is that you need to prepare your portfolio for stormy weather. It’s a lot easier to hold onto your equity investments during difficult times if you have diversified broadly to begin with.

    Albert J. Fredman is a professor of finance at California State University, Fullerton (E-mail: afredman@fullerton.edu). Prof. Fredman is co-author of several mutual fund books.

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