ETFs: The Way to Get Country Diversification

The investment world seems to be coming to grips with the notion that U.S. investors need more foreign exposure. That idea was corroborated in a recent Barron's story in which Charles Schwab said holding 40% of your assets in foreign holdings might be good for some people.

Companies have been selling ever-more exchange traded funds, providing broad and narrow exposures to the world, countries and themes with a global focus. Toward the end of the article, however, the advice goes way off course. There is a quote from a research director at a large bank saying investors "can get the majority of benefits from the emerging-markets space by using broader multi-country products," the idea being that single-country funds can be too risky for people with "longer-term goals."

Before following that sort of advice, it's important to understand the drawbacks, the biggest of which is that there may not actually be that much diversification in these funds.

According to the State Street Global Advisors Correlation Tracker Tool, the SPDR S&P 500 ETF(SPY Quote) has a 0.99 correlation to the iShares MSCI EAFE Index Fund(EFA Quote) over the past three years. (One is a perfect correlation.) There are two reasons for this.

One is that, by adding more countries, the attributes that make each nation unique are "blended away" and the correlation rises. The other issue is that the EAFE Index Fund is heaviest in Japan and Western Europe. Japan has been in a 20-year funk and Western European countries are more or less like the U.S. Despite the comments in the Barron's article, the EAFE Index might be one of the worst ways to capture foreign diversification.