ETFs: The Way to Get Country Diversification

Contrast the high correlation of the EAFE Index Fund to some single-country fund numbers for the past three years: iShares MSCI Canada(EWC), 0.84; iShares FTSE/Xinhua China 25 Index Fund(FXI), 0.59; iShares MSCI Brazil(EWZ), 0.53; iShares MSCI Malaysia(EWM), 0.76; and the iShares MSCI Chile Investable Market Index(ECH), 0.61. (Chile's is a one-year figure.) These numbers are skewed somewhat as correlations generally went higher in the meltdown but still all are below that of the EAFE Index Fund.

The notion that a single-country index is riskier is the wrong way to look at it. Clearly there are more places to hide by choosing a broad-based fund over a single country, so a better way to think of single-country selection might simply be that investing at the country level requires more work. And it may not be more risk you take on with a country as opposed to more volatility. A country going to zero is unlikely. A more likely negative consequence of being wrong about a country is increasing the volatility of a portfolio when the intention might be to make it less volatile. This means not making too large a bet on any one country.

A final point to make about country selection and the work that would need to be done is that if Charles Schwab is anywhere close to right about 40% in foreign exposure, and I believe he is, then investors would need to learn about many countries and have moderate allocations to numerous countries.

The last decade has not been kind to U.S. equity indexes and it may be a while before they produce "normal" returns, but people cannot afford to go 20 years with substandard results. Investing in many different countries will guarantee nothing, but does it make more sense to own a bunch countries with the highest correlation to the U.S. or countries with different attributes if diversification is what you want? The solution is easy: more foreign exposure. The task, however, will require more work.

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