Foreign or Domestic ETFs For 2007?

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Includes: EEM, EFA, IWV, SPY, VWO
by: Richard Shaw

This article focuses on historical trends in mutual funds inflows and outflows, index annual rates of return, ETF price patterns, ETF portfolio characteristics, sentiment in terms of closed-end fund premiums and discounts, and expectations expressed through puts and calls.

While there are other factors to consider, such as judgments about current and likely economic and world events, trend changing event risks (such as war, bankruptcies or energy crises) and changes in interest rates, we think the indicators discussed in this article provide strong clues to the near future (perhaps 3-6 months).

Mutual Fund Funds Flow:

• Positive trend for foreign funds.
• Ho Hum trend for domestic funds.

The trend for foreign funds in the chart below is taken from the notes to Investment Company Institute data about monthly mutual funds flows in the US for the period 2002-November 2006.

For a good portion of 2002 and 2003, more funds flowed into domestic funds than into foreign funds. For most of 2004 and in 2005 and 2006, the flow of funds into foreign investments exceeded the flow into domestic funds.

In 2005, the average flow into domestic funds was $2.49 Billion/month while the flow into foreign funds as $8.86 Billion/month. In 2006, the average domestic inflow was $2.04 Billion/month and the inflow to foreign funds was $12.31 Billion/month.

About ¼ of the months in 2005 and 2006 were outflow months for domestic funds, while there were no negative outflow months for foreign funds.


The gaps in the chart represents months where the ICI notes did not separate domestic and foreign funds flows.

Annual Total Return Rates 2002-2006:

• Consistently superior emerging and developed markets trend

The rates of return for key indexes representing domestic markets and foreign developed and emerging markets shows the US markets laggings in each of the years 2002-2006. 2006 ended with Russell 3000 up 14.35%, lagging behind the MSCI EAFE at 22.50% and the MSCI Emerging Markets at 23.72%.

The chart below shows 5 years of outperformance by foreign over domestic funds.

It is important to note that most of the return for the EAFE was due to a decline in the exchange rate for the US dollar, which has declined about 1/3 in value according to the US Dollar Index. The EAFE in local dollars rose only 9.18%

The emerging markets, on the other hand, got some boost from exchange rates, but clobbered the US markets either way, rising 20.90% in local dollars (23.72% in USD).


Moving from the theory of indices to the down and dirty reality of ETFs you can buy and sell, the five year trend is solidly in favor of foreign over domestic funds.

IWV EEM EFA chart

Portfolio Characteristics:

• Superior Sharpe Ratio for foreign ETFs over US ETFs (Sharpe = return in excess of risk free return divided by Standard Deviation of return)
• Comparable Yield, P/CF, P/B and expenses for all ETFs (excluding high expense for MSCI Emerging Markets Index (NYSEARCA:EEM))

Foreign funds make slightly more sense on the basis of portfolio characteristics.

Sharpe chart


Sentiment:

• Strong positive sentiment for emerging markets shown by narrowing discounts on closed-end funds

Expectations:

• Positive expectations for domestic and developed foreign markets
• Cautious to negative sentiment for emerging markets

Puts and calls on ETFs 1 year out at-the-money show positive expectations for SPDRs (NYSEARCA:SPY) and MSCI EAFE Index (NYSEARCA:EFA), but level and possible negative expectations for EEM.


Predictions of continued dollar exchange rate declines for the near term are bullish for developed markets (based on their out performance through exchange rates in 2006).

The indicators we’ve covered in this article make us feel that there is more UP than DOWN probabilities for foreign markets in early 2007. We’ll think about late 2007 later. We will be increasing our foreign allocations for 2007.

Related ETFs: iShares Russell 3000 Index (NYSEARCA:IWV), Vanguard Emerging Markets Stock VIPERs (NYSEARCA:VWO)