International ETFs: How to invest in foreign and emerging markets
For new and seasoned investors alike, taking a global approach to your investments can help provide diversification and multiple ways to benefit from the growth in the world economy. While putting your money in foreign markets might sound complex, there are exchange-traded funds (ETFs) set up to streamline the process and make it easy for those in the U.S. to invest internationally.
Although this type of investing may appear unnecessary to some, having assets outside the U.S. can serve as a valuable hedge against domestic market fluctuations and provides the potential for greater returns in both developed and emerging markets.
Here’s what you need to know about identifying the best international ETFs and how they might fit in your portfolio.
Developed, emerging and frontier markets: How they differ
When investing internationally, the first step is to understand how world markets are classified, as each country and geographic region carries varying risk/reward profiles.
The main categories are developed, emerging and frontier markets.
Before we dive into classification, remember there is no single country or region that provides total exposure to the global economy — thus the case for diversifying internationally.
In developed markets, you’ll usually find countries with mature capital markets, broad regulatory bodies, advanced infrastructure, and other economic stability factors. Countries like the United Kingdom, Switzerland and Japan belong to this category. As a result, their investment profiles closely match the United States.
In emerging markets, you’ll typically find countries that exhibit accelerated economic growth, often driven by younger populations, infrastructure modernization, technological advancements and higher levels of consumer spending. Countries like Brazil, India and South Korea are some examples.
Investing in emerging markets presents opportunities for higher returns than developed economies. However, there’s also a greater risk for losses as these countries tend to experience more frequent economic and political instability.
Meanwhile, frontier economies have limited links to the global financial system as their capital markets might be too small or underdeveloped. Therefore, trading volumes are often low and investment participation is limited.
Among the three groups, frontier markets carry the highest risk of political, economic and currency instability. Nevertheless, higher risk generally correlates with the possibility of higher returns, which is why some investors opt to maintain limited exposure to frontier markets.
Countries like Vietnam, Nigeria and Bangladesh are thought to be part of this category.
How international ETFs work
Like domestic exchange-traded funds, international ETFs provide a low-cost option to diversify and access a wide range of investment themes.
Within the ETF sphere, there are two options for how securities are selected: Passive and actively managed funds.
In a passively managed ETF, a fund manager buys a basket of international stocks that make up a broad index. Through one of these investments, you gain exposure to the entire index. This process eliminates the need for fund managers to select individual companies at their discretion. Therefore, management fees are usually low.
For example, the Vanguard FTSE All-World ex-US ETF (VEU) tracks the FTSE All-World ex-US index’s performance. The index includes more than 2,000 stocks of companies in developed and emerging markets in 46 countries, excluding the U.S. By purchasing this ETF, you aim to replicate the benchmark’s performance.
Alternatively, with actively managed funds, investors get access to thematic investing.
Contrary to index funds, active investing depends on a fund manager’s ability to pick securities and provide above-average returns. As a result, these investments often come with higher fees and greater volatility than passive ETFs.
An example of an actively managed ETF is WisdomTree’s Emerging Markets Local Debt Fund (ELD), which invests in government and corporate bonds denominated in the currencies of emerging market countries like Brazil, Thailand and Colombia.
Comparing US (domestic) vs. international stocks
Even if you chose to own large U.S. companies exclusively, chances are you already have some international exposure. In the twenty-first century, multinational companies derive a significant portion of their revenue from international developed and emerging markets.
By shifting your focus overseas, you can mitigate the risk of what’s called “home bias,” or the tendency for investors to hold the majority of their portfolios in domestic assets. Home bias dilutes the benefits of diversification when trends change.
Consider historical fluctuations in market leadership, which usually alternate between the U.S. and international stocks.
For example, the U.S. market has outperformed international stocks over the past decade, boosted by solid gains in the technology sector. However, until the 2008 global financial crisis, it was international markets that led the way.
With the rapid rise of technological advancements, supply chain and logistics reliance, and other competing factors that come into play in the global economy, international markets could soon retake the lead.
Risks associated with international ETFs
Like all investments, both domestic and international ETFs carry various sets of risks. Those risks can be market-specific such as stock valuations. Or they can be macro risks, such as high government debt levels, which can lead to inflation.
Investments in international stocks come with additional sources of volatility. Factors such as limited market regulation, varying accounting practices, political instability and currency fluctuations could dampen equity returns.
However, according to Vanguard’s research, investors could mitigate some of those risks with the correct diversification levels.
Another risk to consider with international ETFs is the potential for overlap in country weightings. Fund managers often act based on market opportunities. Therefore, equity holdings in specific sectors or regions could be similar across multiple ETFs.
When selecting an international ETF, pay attention to the fund’s top holdings, along with investment distributions across sectors and regions. The key is to align your investments with your desired asset allocation without being overexposed to one area of the market.
Remember, a sector or region might be hot today and then quickly fall out of favor.
Getting started: How to buy international ETFs
Depending on your financial goals, asset allocation and risk tolerance, there are various strategies for investing in international stocks. Your level of financial knowledge and engagement with your investments also plays a factor.
For most investors, passively managed international ETFs are likely the best option. Intended as a buy-and-hold strategy, they provide automatic diversification and free investors from consistently monitoring market developments.
A combination of passive and active managed funds could also make sense for investors with a higher tolerance for risk and volatility.
Once you determine your financial goals, decide what percentage of your total portfolio allocation you will invest in international stocks or bonds.
Vanguard recommends investing up to 40 percent of your total equity allocation in international stocks and up to 30 percent of your bond allocation in international bonds to get the full benefits of diversification.
For example, according to Vanguard’s recommendation, a portfolio containing $10,000 in stocks should have up to $4,000 allocated to international stocks.
After you determine your comfort level, it is time to select the type of international ETFs you want to buy.
Find international ETFs that suit your financial needs
There are plenty of ETF screening tools, including those provided by most brokerage firms. You can screen by factors like geographic region, fees, trading performance, assets under management and so forth. As you narrow your options, the key features to consider are:
- Expense ratios and fees: By default, most ETF providers charge competitive fees. But even at relatively low levels those fees can add up, so make sure to compare apples-to-apples and read the fine print.
- Assets under management (AUM): Many investors use this figure as a vote of confidence to assess other investors’ engagement with a particular ETF. Along with AUM figures, it might be helpful to check the longevity of the fund.
- Fund issuer: Brands are powerful. And that’s no different in the ETF space. Some investors feel comfortable only investing in large asset managers, while others see the value in newcomers. Decide what works for you and your financial needs.
- Fund performance: Numbers don’t lie. So while you do your research, take a look at a fund’s short-, mid-, and long-term performance.
- Trading volume: The more liquid a fund is, the easier it will be to buy and sell. Look at how average trading volume compares to similar ETFs.
- ETF top holdings: By law, fund companies need to disclose their holdings, which is beneficial for investors as it provides transparency. It’s also helpful to decide whether those investments line up with your financial goals.
- Fund flows: Many investors track how much capital flows in and out of funds, often weekly and monthly. Any long-term trends in fund flows are valuable as they paint a picture of investors’ sentiment.
Use the factors above as a guide to discovering your next international ETF.
Having limited exposure to foreign stocks may seem like a positive when the U.S. market is outperforming. But when global trends shift, you could miss out on the potential for higher returns and lower volatility.
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