Understanding Single-Country ETFs

Roger Nusbaum submits: There was an article in Barron's last Tuesday that quoted several different money managers opining about how much foreign exposure they have now or how much they plan to have in the future.

One advisor was quoted saying that, "her firm will not allocate more than 15% of a client's portfolio to one sector, including international, as a way to control risk." This seems like a peculiar comment to me. I count 22 single-country ETFs from iShares. Of the 22, twelve have a correlation of less than 0.60 to the S&P 500. I would say that risk control is the result of how a portfolio's components are blended, not whether a specific holding is volatile or not. Of the 20 single-country funds that existed from 1/1/2001-12/31/2002, nine outperformed the SPX, this during a particularly bad run for the U.S. market. Of those nine, seven outperformed dramatically.

The manner in which this person is quoted (here I am saying the above quote could be out of context) makes it seem like she really does not understand foreign investing or diversification. Assuming the quote was wrong and she does know, you will no doubt encounter people that may be looking to help you that don't know.

Here I think the onus is on you. It is not that difficult to learn the big macro for some other countries and to also learn generally how volatile those markets are, what makes them tick, how they correlate to the U.S. market and how they could incorporate into a portfolio.

If your plan is to manage your own portfolio I think you need to be willing to explore and learn about this sort of thing. I don't think you can just count on hiding out in iShares EAFE (EFA) either. It looks like it listed in summer 2001. From its inception until 12/31/2002 it dropped by the same amount as the S&P 500.

EFA has never been my first choice for foreign diversification. I own it for a couple of accounts where circumstantially it is what fits, but there are countless alternatives that are superior.

Comments

[Leonard Goldner]

You state there are countless of investments superior to EFA but do not indicateeven one. I'd like to know what some of them are.

[Tim Moore]

I have a sister in Cape Town. Her financial advisor has her dramatically overweight S. African equities. Ditto for a UK based brother and ditto for another sister based in Australia. The lesson 'it is easy to sell clients domestic large cap stocks'. I could not agree more with you comments and think that people with sector orientation should look at new ishares global sector funds.

[Geoff Considine]

Hi Roger:

Correlation of 0.6 is not that impressive as a diversifier. Warren Buffett argues that it is a good idea to invest in U.S. firms with big overseas sales, and this applies to diversification too:

financial.seekingalpha.com/article/20416

Coke (KO) has a correlation of 0.36 to the S&P500 (monthly returns). JNJ has a correlation of 9%. Both have low correlations to EEM and EFA, too. Both are major BRK holdings.

Also, many investors have no real idea how risky individual countries are. The last few years have been pretty tame in terms of overseas risk. Historically, individual countries have been far more volatile:

etf.seekingalpha.com/article/17957

[Roger Nusbaum]

The US used to be more volatile too.

[Geoff Considine]

Yes--and that is a key point. We are in a period with low volatility globally. VIX and other measures of volatility are in a major low and have been low for a couple of years. If you look at a chart of VIX

finance.yahoo.com/q/bc?s=%5EVIX&amp ;t=my

you will note this. When VIX resurges--assuming that market volatility will eventually move up to historical levels again--this has some important implications. Among them, a lot of fairly low-volatility investments will probably get more volatile again, both U.S. and international. Many investors are implicitly assuming that volatility will stay low. I bet that it will not.

[Geoff Considine]

Ohh--forgot to note: the options markets for SPY and EEM both imply reversion to historical (and much higher) volatility levels.

[valuemaster]

I think the reason more investors and money managers do not invest outside of their home country is because investing overseas is well, "foreign" to them. I had to introduce international investing to my investment advisory firm (thus becoming their Director of International Research). The U.S. market is about 40% of the world's stock market capitalization, leaving 60% outside of the U.S. Why would an investor ignore 60% of the oyster? I would rather invest in an undervalued market versus an overvalued market any day, just like I would invest in an undervalued stock over an overvalued stock.

[Geoff Considine]

By the way, I do agree with Roger's basic premise. Saying that 'international' is a single asset class/sector sounds foolish, but I have not read the article.