Foreign Exposure: Mutual Funds vs. EFA? Neither...

Includes: EFA, EWA, EWC, IAF, IRL, SPY
by: Roger Nusbaum

roger nusbaumRoger Nusbaum submits: The stock market has been very cooperative while we are away this week -- flat or up makes things a little easier.

A reader asked what I thought about mutual funds from Vanguard or Fido as substitutes for iShares MSCI EAFE (NYSEARCA:EFA).

Well, I am not a fan of EFA or any broad-based, total (or close to total) foreign market fund. A big reason to own foreign stocks is so they might offer diversification to a portfolio; zigging when the U.S. is zagging is how I like to think of it.

I used a similar chart in a recent TSCM article. The time captured is mid-2001 to mid-2003 and it compares EFA to S&P 500 Index (NYSEARCA:SPY).

While I was not concerned about increased correlations during the recent dip, I would be concerned about increased correlation the next time we have another market that looks like the one in this chart.

During the time period charted the Australia All Ordinaries (ticker ^AORD on Yahoo) declined by only 15%. The couple percentage points from EFA is not significant to me, but the 15 percentage points from Australia is.

Canada, as measured by iShares Canada (NYSEARCA:EWC) correlated closely to the U.S. until November 2002, before outperforming big time, so I am not sure what to expect from Canada during the next bear market.

Each country offers different things to a portfolio, but when all (or most) countries get lumped into one product a lot of the things offered by the countries individually get blended away as evidenced by the above chart.

To answer the reader's question: I prefer the flexibility of the ETF format, so I'll say EFA -- but you now know how little I think EFA brings to the table in terms of diversification. It does offer a chance for outperformance over the S&P 500, but that is a different issue.

The typical account I manage probably has exposure to ten or eleven foreign countries via individual stocks. In terms of priority I would say Australia is first followed by Ireland and then Norway. You can capture Australia in an ETF [with the iShares MSCI Australia Index Fund (NYSEARCA:EWA)] or a CEF [with the Aberdeen Australia Equity Fund (NYSEMKT:IAF)]. While there is no ETF for Ireland there is a CEF [The New Ireland Fund (NYSE:IRL)], though I use an individual stock, not the CEF. And for Norway there are only individual stocks unless you have direct access to the Oslo Exchange.

SP vs EFA vs GSPC 19 04 2007