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

Roger 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 (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 (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 (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 (EWA)] or a CEF [with the Aberdeen Australia Equity Fund (IAF)]. While there is no ETF for Ireland there is a CEF [The New Ireland Fund (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.

Comments

[David Jackson:]

Hi Roger,

Isn't the reason why Canada has outperformed because of its concentration in energy? In other words, iShares Canada (EWC) doesn't really give you foreign exposure; it's more like an Energy sector ETF.

On Australia, Norway and Ireland: what makes you like them so much relative to other countries?

David

2007 Apr 19 06:26 PM

[Roger Nusbaum:]

David, the short answer is maybe, lol. EWC is 55% energy. Clearly Canada benefits from strong energy prices. If, and this is what I don't know, oil goes up in the next bear market for US stocks then Canada would probably be a good place to hide but really I offered nothing forward looking in the post about Canada because I am not sure.

Australia has a very low correlation to the US due, I beleive to having a very different type of economy; no recession since 1991. Ireland's gov't made a decision in the late 1980s that it was going to be the best place for foreign companies to do business with may pr0 growth policies like a 12.5% corporate tax rates. Ireland has been booming almost ever since. Number 2 GDP in Europe per capita (i think number two maybe 3) and estimated to be number one sometime next decade.

Norway is oil that does not come to the US (at least not very much) so they are not dependent on US growth. They have their financial house in impecable order and as more of a commodity based economy (like Oz) as opposed to the US' service based economy I believe it should be a different points in its economic cycle than the US which is my idea of what foreign diversification is.

True enough both Norway and Australia appear to have more rate hikes in front of them.

2007 Apr 19 07:15 PM

[Tom B:]

Long term, Canada should be a country which might see some benefit from global warming, in contrast to places at lower latitudes. This is relevant to a long-term holder, like me.

2007 Apr 20 08:42 AM

[Roger Nusbaum:]

as in it won't get as warm in Canada? Interesting, I hadn't thought about that.

2007 Apr 20 12:47 PM

[Internet2k4:]

Re the global warming play: read the science first. We'll all be dead before anybody feels the heat. Not to say Al Gore isn't eventually right, but when is he right? Investors know something about the difference between next week (trader), a couple of years from now (cyclical) and after I'm dead (secular) trends.

2007 Apr 21 03:24 PM