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Minding the P's & Q's of International ETFs

Overseas stocks have been red hot. How to play it.
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International exchange-traded funds are all the rage.

Over the past year, about 40% of net cash flow into ETFs has gone into international products, according to Paul Mazzilli, director of ETF research at Morgan Stanley. In the third quarter alone, $2.1 billion of net new assets went into international ETFs, while domestic large-, mid- and small-cap ETFs all experienced net outflows, he reports.

"A lot of money has gone into international ETFs

largely because it's the easiest simplest way

for U.S. investors to get broad, diversified exposure," Mazzilli writes.

Strong performance has clearly played a part in investors' desire for overseas ETFs. The largest international ETF in terms of assets, the

iShares MSCI EAFE Index


, which tracks one of the best known benchmarks for non-U.S. stocks, is up almost 20% year to date and is one of several international ETFs to have outperformed the

S&P 500

over the past one-, three- and five-year periods.

As with any area that's in vogue, ETF providers are taking notice and launching oodles of related products. As of Oct. 31, there were 81 international equity ETFs, up from 49 at the end of 2005, according to the Investment Company Institute. Assets in those ETFs have risen to $95.35 billion from $65.2 billion.

"The product developers aren't stupid, says Matthew Hougan, senior editor of the Journal of Indexing and Web site "There's been such huge asset growth in international ETFs over the last few years

and that's why it's been a big area of focus" for new product offerings.

For example, WisdomTree Investments launched 10 international sector ETFs in October (adding to the 14 international products it already has trading). And the company recently filed for 21 new international products designed to track myriad international segments from dividend-paying Malaysian stocks to high-dividend yielding stocks in the U.K.

Meanwhile, State Street Global Advisors recently launched its first two international ETFs, both focused on Japan. The company has several more in filing that it plans to roll out over the next few months, including an international REIT ETF. PowerShares has a couple of international ETFs on the market and recently filed for 35 more.

This influx of new products is a good thing as it provides investors with more options and can lead to lower costs as competition heats up. But it also means that investors have to be careful about where they're putting their money, especially because investors are prone to chase performance.

International Powerhouse
As overseas markets continue to outperform,
money and ETF offerings have followed

"A lot of the reason that people became interested in international investing was that the international market was simply doing that much better than the U.S. market was," says Lipper senior research analyst Andrew Clark. However, a lot of the strong performance came from a weakening dollar, which hit a 20-month low vs. the euro on Monday.

But there's no guarantee the dollar's slide will continue, and investors with 50% or 60% international exposure should "consider paring that back somewhat, especially if you have exposure outside of the" European Union, says Clark, who believes about 25%-30% international exposure is appropriate for most investors.

A "relatively safe" international ETF to invest in, he says, is the

iShares MSCI EMU Index Fund


, which gives equal weight exposure to the EU countries.

Other areas he believes are good investments include mainland China, Russia and Brazil. These "should be everyone's favorite long-term investments," he says. "They all have terrific opportunities that will come on line at different times."

In general, when choosing an international ETF, there are a few things to keep in mind.

Go Broad and Deep

Investors should "look for funds that track an index that is broad and deep," says Hougan. Specifically, he recommends products that track wider segments of the international market as opposed to buying an ETF that represents a single country.

Morgan Stanley's Mazzilli agrees: "Market leadership among countries can change significantly," he writes. "Since no single country has consistently outperformed its peers, investing in broad-based international index-linked ETFs can help not only to reduce volatility, but also to achieve competitive returns for the overall portfolio."

But if you are looking for exposure to specific countries or regions, as many are, it's important to know exactly what the index is tracking.

For instance, both the

iShares FTSE/Xinhua China 25 Index Fund


and the

PowerShares Golden Dragon Halter USX China Portfolio


imply exposure to China. But they are actually very different in that FXI follows 25 of the largest and most liquid Chinese companies while PGJ tracks U.S. -listed companies doing business in China.

Also, Hougan says some ETFs consider themselves international products but actually primarily hold American depositary receipts (ADRs), which are receipts for the shares of a foreign-based corporation held by a U.S. bank. One such product is the



, which tracks the performance of ADRs from Brazil, Russia, India and China. While there is nothing inherently wrong with holding ADRs, sometimes you get a narrower selection of companies.

Expenses also should always be a consideration.

International ETFs have a wide range of expenses but they tend to be higher than domestic products.

Sometimes a particular product provides the only way to get exposure to an area and that may justify the cost. For instance, the

iShares MSCI Japan Index


carries an expense ratio of 59 basis points while the

Vanguard Pacific ETF


is just 18 basis points. However, the latter product gives you only 75% exposure to Japan, so it's not as pure a play on Japan as the EWJ.

On the flip side, two products may be very similar but have a big gap in costs. For example, the

Vanguard Emerging Markets ETF


costs 30 basis points compared with 75 basis points for the

iShares MSCI Emerging Markets ETF


. The iShares ETF used to justify its higher expense because it included Malaysia and Russia, which the Vanguard product didn't. But Vanguard has since included those areas, so now the products are almost identical. Yet the iShares ETF is significantly more expensive. Hougan says this will likely put pressure on Barclays to lower its fee.

Another factor to consider is tracking error, or the difference between the performance of the benchmark and the ETF trying to replicate it.

"The managers and academia seem to like to look at tracking error," Mazzilli says. But "I'm not sure tracking error is that important" if the tracking error is say 50 basis points and the ETF is up 80% a year, such as Brazil has been for three years.

Investors should also be aware of bid/ask spreads, which is the difference between the price that a seller is asking for and the price that a buyer is looking to pay. This is particularly true with international ETFs. One reason is that spreads tend to widen with less trading volume, which is the case with some of the smaller, more niche international products.

Finally, there are added risks with international products because global markets are open when U.S. exchanges are closed. The risk of overseas, overnight events affecting international ETFs that trade in the U.S. tends to lead to wider bid/ask spreads.

"For new ETFs with low assets, it pays to pay attention to that because you could get dinged going in and out of funds," Hougan says.