ETF Talk: Your Passport to Diversification

The same advantages of broad-based market funds that I shared in last week’s ETF Talk also extend to international funds. Both kinds of ETFs provide diversification, low expense ratios, trading flexibility and tax efficiency through index investing. In addition, both also allow the use of limit orders and short selling.

With the U.S. economy in poor shape, it is now more important than ever to diversify strategically, and international ETFs could be especially useful in helping you to do so. When the stock markets recover, emerging markets likely will show the greatest gains. For that reason, I want to bring the iShares MSCI Emerging Markets (EEM) to your attention. It has about $12 billion in assets and offers the potential to soar when the markets recover.

Another fund to watch is the iShares MSCI EAFE Index Fund (EFA), with about $29.4 billion in assets. It contrasts with EEM by investing at least 90% of assets in the securities or investment instruments of the underlying index of developed international markets.

I also recommend becoming familiar with iShares FTSE/Xinhua China 25 Index (FXI). The fund generally invests at least 90% of its assets in the securities of the index or in American Depository Receipts (ADRs), Global Depository Receipts (GDRs) or Euro Depository Receipts (EDRs) that represent securities in the index. FXI also invests in other assets such as futures contracts, options on futures contracts, options, and swaps related to the index, as well as cash and cash equivalents.

Many financial advisors recommend investing at least 20% of your portfolio in overseas funds. That is not a bad idea at all. The reasoning is that those funds are supposed to rise and fall independently of the U.S. market. Well, there has been more correlation than not lately, with virtually all of the world’s markets taking a big hit. However, not all of the markets will recover together. For that reason, exposure to foreign markets helps to offset domestic market swings.

I personally like broad-market international ETFs because of their sheer breadth and liquidity, low expense ratios and narrow bid-ask spreads. These characteristics make buying ETFs better values than foreign stock mutual funds.

In the past year, international ETFs have grown even faster than domestic ones. ETFs that offer international exposure are gaining popularity quickly among investors, according to the Investment Company Institute. In the 12-month period ended Oct. 31, total ETF assets rose 38% to $335.1 billion, while global ETFs nearly doubled to $82.8 billion.

Before you buy any international ETFs, here are a couple of other things to keep in mind. Some ETFs track only indices that have foreign stocks traded on U.S. exchanges. Others track indices based on foreign stock markets. What’s the difference between the two varieties? ETFs that track foreign stocks traded on U.S. exchanges tend not to be as diversified as ETFs based on foreign markets. However, an advantage of buying a basket of ADRs is that the U.S. market usually has tighter and higher accounting standards than most foreign markets.

So, if you want some additional portfolio diversification, get your passport out and go international.

If you want further guidance about which ETFs to trade, check out my ETF Trader service by clicking here. As always, I am happy to answer any questions that you have about ETFs. To send me your questions, simply click here. I will try to respond in a future ETF Talk.