ETF Basics: Invest Globally, but Cautiously

Posted on February 7, 2011 at 8:24 AM PDT by

Not all foreign stock investments are created equal. A few weeks ago, we wrote about owning stocks in companies based in emerging markets (Brazil, Russia, India, China) and the different types of risks and returns one can expect. The exciting growth in these countries also comes with a fair amount of risk, including governments with onerous tax rates, state-imposed price controls, outdated securities laws, corruption, or risk of wars and violence.

Egypt brings these risks home. If you want to invest in the Egyptian stock market, you can purchase shares of an exchange-traded fund (ETF) called the Market Vectors Egypt Index ETF (symbol EGPT), which holds all the important stocks in Egypt. When protests broke out last week, the markets decided that all of the largest companies in Egypt were worth 25 percent less than they were a day before, and EGPT fell by that amount!

Investing in foreign companies in the 27 developed countries (such as the UK, France, Germany, Japan, Australia, and Canada) gives you further diversification and is much less risky. In fact, over long periods of time, these economies perform like the U.S. stock market. Between 1970 and 2004, those stock markets appreciated 10 percent per year compared with the S&P 500 growth of 11 percent.

Every retirement investor should own these foreign stocks because they reduce risk in a portfolio in two key ways. First, you’ll own stocks in other currencies. If the U.S. dollar declines against the Yen or the Euro, these stocks will appreciate. Second, other countries have their unique responses to their own economic circumstances, their governments, their populations, and tax rates-all of which are different than the U.S. In the 1980s, the experts said Japan was going to take over the world and their stock market rose 28 percent versus the U.S., which returned 17 percent. In the 1990s, Japan’s markets tumbled and only recently have begun to recover. Demographics can also impact a country and the value of its companies. For example, other countries don’t have “baby-boomers” and their populations are aging in different ways.

Therefore, owning a basket of developed foreign stocks provides equity ownership that doesn’t always have the same fluctuations as U.S. stocks, which reduces risk in a portfolio.

In our MarketRiders retirement portfolios, we allocate about 30 to 35 percent of our equity exposure (not fixed-income), to non-U.S. stocks. Most of that allocation goes to developed countries instead of emerging-market countries.

Investors should own foreign developed country stocks through ETFs instead of mutual funds. The costs are low and active mutual fund managers statistically don’t do better than the indexes they attempt to beat. Also, foreign country mutual funds tend to have very high fees-it’s expensive to fly fund managers all over the world to research companies in foreign countries. Instead of paying high fees, just buy an ETF that holds all of the stocks in all of the countries that matter.

We recommend three ETFs in most of our portfolios. By owning shares in Vanguard European ETF (VGK), you own a basket of 481 large companies in 16 European countries and pay only 0.16 percent in annual fees, which is 10 percent of the cost of comparable mutual funds. Adding Vanguard Pacific ETF (VPL) gives you ownership of 493 large companies in Japan, Australia, Hong Kong, Singapore, and New Zealand. We allocate a small amount to iShares MSCI Canada Index (EWC), which charges 0.53 percent in annual fees.

Here’s the best part: With these three ETFs, you don’t have to worry about which country will grow faster, or whether Toyota will do better than BMW because you will own all of these stocks and capture the growth of these countries and their currencies. As for uprisings, you might sleep better with less risk of that occurring in these countries.