Finding Fortune In Foreign ETFs

Foreign ETFs and U.S. Markets

The introduction of ETFs that concentrate primarily on overseas investments has opened a new door of opportunity for investors. Instead of relying on their stock-picking skills, investors now have the option of investing in specific countries or regions of the world. This type of investing is also different because rather than using the bottom-up approach that many investors implement when picking individual stocks, the best way to choose the appropriate foreign ETF is a top-down method.

Since the start of this century, the U.S.'s role as a leader in world economic growth has diminished as a number of other countries step to the front of the line. The two countries that most investors think of when they are searching for growth are China and India. With real gross domestic product growth rates well above U.S. rates, it is only natural for the stock markets to join in the expansion as investors seek out high-growth opportunities. This process allowed foreign markets to grow while U.S. market growth slowed and, consequently, may have caused some losses in U.S. markets.

When growth in the U.S. slowed in the early 2000s, the stock market was directly affected. During the first six years of the twenty-first century, the S&P 500 averaged a loss of 1.4% annually, thanks in large part to slowing growth. During the same time frame there were a number of countries that produced sizable annual gains. One of the leaders was the Australian ASX All Ordinaries Index, which had an annual gain of 7.5% between 2000 and 2005 . This negative correlation between the Australian and U.S. stock markets is one of the primary benefits of investing in foreign ETFs because when markets move opposite to one another, by investing in both markets, investors achieve greater diversification and protection from risk.

Foreign Economic Risk Factors

Other factors to consider when choosing specific foreign ETFs for your portfolio include country-specific risk and the risks involved with investing in emerging versus developed countries. All country-specific ETFs will carry significant country-specific risk. This means that the performance of the investment will be very dependent on the country's overall state. Investors can reduce country-specific risk by choosing an ETF that invests in an entire region, rather than one particular country. For example, instead of investing in a Brazilian ETF, an investor could opt for lower risk by investing in an ETF that encompasses a number of South American countries.

The level of risk that investors take on will also be determined by whether they invest in ETFS that focus on developed countries or ETFs that focus on emerging countries. Historically, developed countries have not grown as quickly as emerging countries and, therefore, ETFs from developed countries are generally regarded as more conservative. For most investors, an appropriate mix of emerging and developed ETFs depends on risk tolerance. Investors who are less willing to take on risk would probably be more comfortable with investing in fewer emerging country ETFs and vice versa.

Hedging Against a Weak Greenback

After reaching its peak in 2001, the U.S. Dollar Index began breaking down - a weakness that, in 2006, has yet to subside. With an increasing federal budget deficit and current account deficit , it appears that the greenback will continue its long-term downtrend. If this trend continues, investors may want to hedge their portfolios against it by investing in foreign ETFs. This strategy will allow investors to take advantage of the decline of the U.S. dollar, which has resulted in a boost in profits for companies based outside the U.S.

The commodity sector is another area that has been able to profit from a weak U.S. dollar. A number of the large commodity companies based overseas are held by foreign ETFs. For example, iShares MSCI Brazil Index ETF(EWZ) has more than 50% of its assets in commodity-related stocks. From 2002 to 2005 this ETF was one of the best performing ETFs as commodities boomed and the U.S. dollar fell. Canada is another country rich in natural resources that has benefited from the commodity boom and weak greenback. The iShares MSCI Canada Index ETF (EWC) boasts returns of more than three times those seen on the S&P 500 between 2002 and 2005. These examples suggest that successful ETFs can be found in both developed and emerging countries (Brazil is considered a risky, emerging country whereas Canada is more conservative and already developed). This is where asset allocation and diversification become important in selecting the appropriate ETFs for your portfolio.

Specific Foreign ETFs