As seen in... 
July 24th, 2006
Do-It-Yourself International Indexing
The EAFE Index is a lopsided bet on Japan and Britain. You might do better with a more broadly diversified collection of country-specific funds.
By Carl Delfeld
What’s your benchmark for foreign stocks? If you are like most investors, it’s Morgan Stanley’s Europe, Australia and Far East Index. Better known as EAFE, the index covers 21 foreign countries and 1,200 common stocks. You can own the index by buying an EAFE fund such as the Merrill Lynch International Index. But this kind of passive investing may be a little too passive. It leaves you at the mercy of the country weightings built into the index.
The version of EAFE commonly used in the investment community weights countries on the size of their stock markets. This forces an EAFE fund to allocate 49% of its assets to Japan and the U.K. The allocation to the far more dynamic economy of Ireland (see story, p. 154) is only 0.8%; Austria gets 0.5%.
A Little of Each
Try this mix: a 10%
weighting to each of
the first nine ETFs
below and 5% to each
of the last two. |
| ISHARES FUND |
1-YEAR TOTAL RETURN |
| Australia |
15.6% |
| Austria |
22.3 |
| Brazil |
45.0 |
| Canada |
26.1 |
| China |
31.0 |
| Germany |
21.1 |
| Japan |
26.3 |
Singapore
|
17.6 |
| Switzerland |
22.4 |
| Hong Kong |
11.2 |
| Malaysia |
6.3 |
| Return as of June 16. Source: FT Interactive Data via FactSet Research Systems. |
What about buying an actively managed fund? You’ll pay a lot more for it than for an index fund, and you’ll still run the risk of a lopsided portfolio, one that shares the big-market bias of the index. Most international equity managers will hug the index’s country weightings or deviate from them only slightly.
This state of affairs presents the independentminded investor with an opportunity to beat the averages. Buy index funds within each market, but weight your countries according to their price levels (P/E multiples, that is), degree of governmental fiscal discipline, growth potential, capital flows, currencies and pace of market reforms.
An excellent investment tool for implementing this strategy involves the 22 country-specific exchange-traded funds that go under the iShares banner. These ETFs, sponsored by Barclays Global Investors, have a combined $193 billion of investor money. Among the 22: Japan’s iShares, containing 281 stocks selected to track the Nikkei 225 index; Singapore’s, with 42 stocks; and Switzerland’s, with 39.
Before deciding which countries to buy, you can look under the hood of an ETF by going to its Web site. Three of the five-largest holdings in the Singapore iShares are in banking. If you don’t like banking, underweight that country.
Annual fees for country iShares range from 50 to 74 cents per $100 in assets. Compare those figures with the Class A shares of the Templeton Foreign Fund, which carry annual expenses and 12b-1 fees for marketing totaling $1.40 per $100 in assets and a 5.75% upfront sales charge. In cost iShares rival mutual funds from the dirt cheap Vanguard Group, whose Total International Stock Index Fund (which tracks other MSCI indexes, but not the EAFE) costs 31 cents per $100 annually and also has a 2% redemption fee (proceeds revert to the fund) for holdings of less than two months.
With ETFs, there’s no redemption fee; the discount brokerage commission on 100 iShares Australia is $7, or 0.3%. More important, iShares have not distributed any capital gains during the past four years. Exchange-traded funds trade like stocks, so you can buy and sell them throughout the trading day. You can also use risk-management tools like trailing stop-loss orders or options. Sponsors do not hedge ETFs against the dollar, which means currency swings can work for or against you.
Which iShares are attractive? The Austrian iShares are an excellent way to take a stake in low-P/E eastern European markets. Singapore and Hong Kong allow you to bet on China’s economic growth. Australia represents a welldeveloped and diversified economy at the heart of Asia-Pacific growth and now capitalizing on the commodity booms. Switzerland is a safe haven in times of instability, and Canada provides an energy play.
To tap into the high growth rates of emerging markets consider the iShares of countries such as Brazil and Malaysia. For countries that do not yet have an ETF, reasonable proxies are closed-end funds like the Morgan Stanley India Investment Fund, the Indonesia Fund and the Thai Capital Fund. Use these emerging markets in your portfolio as you would spices in a cake—small doses are best.
