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By Patricia Oey

While European leaders appear to be moving forward with a plan to address the ongoing sovereign debt crisis, there is plenty of uncertainty as to what lies ahead. Uncertainty begets market volatility, so more risk-averse investors looking for international exposure might want to consider lower-volatility funds with relatively lower European exposure.

To identify these funds, we screened the universe of international-equity ETFs using the following criteria:

1. Equity Region Greater Europe < 50
As a point of reference, the developed-markets MSCI EAFE Index (Europe, Australasia, and Far East) has a 66% exposure to European stocks and the developed- and emerging-markets MSCI ACWI ex-US (All Country World Index, ex-US) has a 50% exposure to European stocks.

2. 12-Mo Yield > 3
We added a dividend screen as a proxy for quality, as we think dividends can be a sign of good management and corporate stewardship. Also, in this low-return, low-yield environment, we welcome any other additional source of returns.

3. Sortino Ratio 3 Yr (Mo-End) > 1.13
International equities tend to be more volatile than U.S. equities, especially in the short term, due to currency effects. Over the past three years, certain categories within international equities have experienced high volatility, but strong performance as well. Instead of using standard deviation or the Sharpe ratio, which penalizes both upside volatility and downside volatility, we used the Sortino ratio, which is a measurement of return per unit of downside risk. It is similar to the Sharpe ratio in that it has the same numerator (the return of the portfolio minus the risk-free rate) but instead of using the portfolio's standard deviation as the denominator, the Sortino ratio uses the standard deviation of negative returns only. In simpler terms, the Sortino ratio considers only downside volatility as risk. The three-year Sortino ratio for the MSCI EAFE Index and MSCI ACWI ex-US was 0.89 and 1.13, respectively, so we screened for funds with a Sortino ratio that was higher than 1.13. At this time, the Sortino ratio is not available on the Morningstar.com ETF screener, but we are considering adding this criteria in our next upgrade.

Our screens generated a list of about 10 funds, and after eliminating emerging-markets, single-country, and very small funds, we were left with four ETFs.

WisdomTree International SmallCap Dividend (NYSEARCA:DLS) is a small-cap, developed-markets fund that has a relatively low 38% exposure to European securities. This ETF weights its constituents based on annual cash dividends paid and currently has a yield of 4.2%. We like the dividend-weighting methodology, which is a straightforward measure of value that is not affected by variances in accounting standards across countries. As for small-cap international stocks, we like them for two reasons: lower correlations to U.S. stocks relative to international large caps, and the small-cap premium (the tendency for small-cap stocks to outperform large-caps over long periods). Small caps usually cater to domestic markets, and over the past 10 years, the correlation between the MSCI EAFE Small Cap Index and the S&P 500 was 80%, lower than the 90% correlation between the MSCI EAFE Index and the S&P 500.

DLS has also offered these diversification benefits without excessive additional volatility. Its five-year standard deviation of around 23% is in line with that of U.S. small caps, even though large-cap international stocks are more risky than the S&P 500. At this time, the risk for DLS is its large exposure to Japanese stocks (39% of the portfolio). Historically, Japanese equities have helped reduce volatility, and the fund's returns were driven by the strong appreciation of the yen over the past five years, and not by the performance of Japanese stocks. A slowdown in the yen's appreciation and continued underperformance of Japanese equities could negatively affect DLS in the future. This ETF's expense ratio of 0.58% is in line with international small-cap funds'.

First Trust DJ Global Select Dividend (NYSEARCA:FGD) is a developed-markets fund that also has a 20% weighting in U.S. stocks. This ETF weights its components by dividend yield, but it first screens for dividend quality to avoid stocks that may be paying an unsustainably high dividend. This ETF's three-year Sortino ratio of 1.86 is the highest among broad developed-markets funds due to the fact that it holds none of the large U.S. and European banks--most of its financial sector holdings are in Australian banks and U.K. insurance companies. This ETF's heavy weighting in U.S. utilities also helped support strong returns over the past year. Its yield is currently 4.8% and its expense ratio is 0.60%.

The easiest way to avoid Europe is to invest in an Asia-focused fund, such as WisdomTree Asia-Pacific ex-Japan (NYSEARCA:AXJL). This ETF invests across developed and emerging Asian countries (excluding Japan), but its holdings are dominated by Australian (25% of the portfolio) and Hong Kong companies (19%). Like DLS, this ETF is a dividend-focused fund and has a current yield of 4.7%. AXJL takes the 300 largest companies from the Asian region and weights each constituent by annual cash dividends paid. Relative to broad international funds, AXJL has a lower correlation to U.S. equities, as most of the large caps in this fund don't compete with the large-cap multinational financial, consumer, energy, and health-care firms from the U.S. and Europe. However, potential investors in this fund should have a long-term positive outlook on China and the region. Although China accounts for only 11% of the fund, its economy has an outsized influence on this fund, as many of its holdings do business with, or invest in, China.

A fund with a similar theme is iShares MSCI Pacific ex-Japan (NYSEARCA:EPP). However, this fund is different from AXJL in that it invests only in developed Asian countries, which includes Australia (which accounts for 64% of EPP's portfolio), Hong Kong (20%), and Singapore (13%). While companies from these countries may seem less volatile because they are domiciled in countries with well-developed capital markets and rule of law, that is not necessarily the case. One risk to note is this fund's 19% weighting in Hong Kong and Singapore financial firms. Many of these firms are property-development companies with heavy exposure to real estate in China, where the government has tried to tamp a potential bubble. This fund's exposure to the Australian dollar through this fund's Australian holdings is also a source of risk, as the Aussie dollar is considered a commodity currency whose exchange rate can fluctuate strongly during periods of market volatility. Finally, while this fund's 20% weighting in material firms can provide diversification benefits to U.S. investors, who tend to be light on the material sector, it is also a source of volatility. This fund's yield is 4.3%, and its expense ratio is 0.50%.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: 4 International ETFs With Limited Europe Exposure