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) has a 0.99 correlation to the iShares MSCI EAFE Index Fund ( EFA) 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.

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.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.