ETFs: A Better Way To Go Abroad

Why savvy global investors are flocking to exchange-traded funds

With U.S. stocks stuck in low gear for two years now, traders have had little choice but to search the globe for opportunities. Their detective work has paid off: The MSCI Europe, Australasia, & Far East Index jumped 20% in 2005 through Dec. 9, more than six times the Standard & Poor's 500-stock index's 3% gain for the same period.

Analysts expect more of the same in 2006. Despite the recent rally, many foreign markets are still cheaper than the U.S., says Jeffrey D. Saut, managing director of investment strategy at Raymond James & Associates (RJF ). Investors, he says, ought to have at least 20% of their portfolios overseas, with healthy chunks in fast-growing countries such as Brazil, Malaysia, and Thailand.

Fair enough. But the trick to international investing is finding the right tool for the job. It's difficult for Americans to buy foreign stocks directly. U.S. proxies for foreign stocks, called American depositary receipts, are available only for a small fraction of the publicly traded companies around the world because of strict listing requirements in the U.S.

Mutual funds, meanwhile, are rather blunt instruments. Most of them target broad regions; some even try to capture the performance of the entire global equity market. And mutual funds are priced just once daily, at the end of the day. That could pose problems in foreign markets, where local blowups spread quickly.

FREEDOM TO FLEE

Increasingly, globally oriented investors are flocking to exchange-traded funds (ETFs), which are baskets of stocks that typically hew closely to market indexes. In 2005 through October (the latest figures available), $16 billion flowed into international ETFs, up 60% from the same period last year. The appeal? ETFs are bought and sold on exchanges at current prices throughout the day, most have low expense ratios, and some target specific countries, such as Japan, China, even Belgium. The downside: Investors incur transaction costs for every trade they make. But if a storm erupts, brokerage fees are a small price to pay for the freedom to flee.

Experienced traders are partial to ETFs because they can be sold short. If you believe that Taiwan stocks are overheated, for example, you can make a bet on it by shorting the iShares MSCI Taiwan Index Fund (EWT ). You can also hedge or leverage an ETF position with options -- something that is impossible with traditional mutual funds.

Which countries and regions should investors focus on in 2006? Some advisers recommend a simple strategy of overweighting Asian markets and underweighting those in Europe. China's growth is aiding all of the developed economies in the region, particularly Japan and South Korea, while European growth remains slow. Investors who buy this hypothesis can use ETFs to create a long/short trade: long Vanguard's Pacific and short European VIPERs.

ETFs can also be used to play the boom in commodity prices. Dave Fry, founder of the Web site ETF Digest (www.etfdigest.com) and a former managing director at one of John W. Henry's investment firms, JWH Investment Management Inc., says the iShares MSCI Canada Index (EWC ) fund is a good way to get in on the commodities boom. "As long as natural resources are hot, [Canada] will benefit," he says. Gold bugs, meanwhile, have flocked to the StreetTRACKS Gold Shares fund, launched in November, 2004. In coming years, analysts say, several new funds tied directly to the prices of commodity indexes should emerge. "Everyone is talking about looking for alternative asset classes, and the ETFs we're expecting [would] open up a whole set of possibilities," says K. Sean Clark, chief investment officer at Clark Capital Management Group Inc. in Philadelphia.

Eastern Europe shows particular promise for 2006. The economies of the less-developed regions of Europe are forecast to grow by 5% next year and those of the former Soviet Republics by almost 7%, according to the International Monetary Fund. The iShares MSCI Austria Fund (EWO ), which is laden with bank stocks, "is the easiest pure play to capture the financing of Eastern Europe," says Roger Nusbaum, a financial adviser in Prescott, Ariz., who writes about ETFs on his blog, Random Roger's Big Picture (randomroger.blogspot.com).

P-E DISCOUNT

Emerging markets, meanwhile, have been on a tear lately, with the iShares MSCI Emerging Markets Index fund (EEM ) more than doubling since its inception in April, 2003. The Vanguard Emerging Markets VIPERs (VWO ) is up 20% since March. And yet emerging markets trade at a trailing price-to-earnings ratio of 12, according to Bloomberg Financial Markets, well below the S&P 500's 18, with a dividend yield of 2.75%, vs. the S&P's 2%. "There are always going to be concerns [with emerging markets]," says J.D. Steinhilber, president of Agile Investments, an ETF-oriented adviser in Nashville, "but as a long-term investor, you shouldn't be trying to make difficult timing calls."

China continues to defy predictions of a slowdown: The MSCI China index was up 14% in 2005 through Dec. 9. And the good times are likely to continue, says Michael Carty, president of New Millennium Advisors LLC in New York. "China has grown on the advantage of its low wages, but now it's becoming more industrialized, and productivity gains are kicking in," he says. There are two China plays for ETF investors: iShares FTSE/Xinhua China 25 Index Fund (FXI ), which includes the largest companies trading in China, and PowerShares Golden Dragon Halter USX China Portfolio (PGJ ), which includes only companies whose shares are listed in the U.S. New Millennium's Carty favors the former.

The ETF frontier is ever-expanding. One new portfolio, Euro Currency Trust, began trading on Dec. 12. It lets investors bet on the euro, with each share of the ETF representing 100 euros. Expect a slew of new offerings in 2006, say analysts. But India is one country that has proved to be a tough nut to crack. The country's capital markets are notoriously difficult to emulate with a single market index because of the large number of small-cap issues there. An ETF sponsor ought to address that in 2006, says Morgan Stanley (MWD ) ETF analyst Paul Mazzilli. "We get inquiries about it all the time," he says. With the MSCI India Index up 35% in 2005 through Dec. 9, it's no wonder.

By Aaron Pressman

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