International ETFs: How to Invest in Foreign and Emerging Markets
For both new and seasoned investors alike, a holistic approach to your investments can contribute to diversification and multiple ways to benefit from the growth of the global economy. While placing your money in foreign markets may seem complex, there are exchange-traded funds (ETFs) set up to streamline the process and make it easy for the United States to invest internationally.
While this type of investment may seem unnecessary to some, having assets outside of the United States can serve as a valuable hedge against fluctuations in the domestic market and offers the potential for higher returns in developed markets and emerging.
Here’s what you need to know to identify the best international ETFs and how they might fit into your portfolio.
Developed, emerging and frontier markets: how they differ
When investing internationally, the first step is to understand how global markets are ranked, as each country and geographic region has different risk / reward profiles.
The main categories are developed, emerging and frontier markets.
Before diving into the classification, remember that there is no single country or region that offers full exposure to the global economy – so international diversification is.
In developed markets, you will usually find countries with mature capital markets, large regulatory bodies, advanced infrastructure, and other factors of economic stability. Countries like the UK, Switzerland and Japan fall into this category. As a result, their investment profiles closely match those of the United States.
In emerging markets, you’ll typically find countries that exhibit accelerated economic growth, often driven by younger populations, modernized infrastructure, technological advancements, and higher levels of consumer spending. Countries like Brazil, India and South Korea are a few examples.
Investing in emerging markets presents opportunities for higher returns than developed economies. However, the risk of losses is also higher as these countries tend to experience more frequent economic and political instability.
Meanwhile, border economies have limited links to the global financial system because their capital markets may be too small or underdeveloped. As a result, trading volumes are often low and participation in investments is limited.
Of the three groups, frontier markets pose the highest risk of political, economic and monetary instability. Nonetheless, higher risk usually correlates with the possibility of higher returns, which is why some investors choose to maintain limited exposure to frontier markets.
Countries like Vietnam, Nigeria and Bangladesh are believed to fall into this category.
How International ETFs Work
Like domestic exchange-traded funds, international ETFs provide an inexpensive option to diversify and access a wide range of investment themes.
In the field of ETFs, there are two options for security selection: passive funds and actively managed funds.
In a passively managed ETF, a fund manager buys a basket of international stocks that make up a large index. Through any 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. As a result, the management fees are generally low.
For example, the Vanguard FTSE All-World ex-US ETF (VEU) tracks the performance of the FTSE All-World ex-US index. The index includes more than 2,000 stocks of companies in developed and emerging markets from 46 countries, excluding the United States. By purchasing this ETF, your objective is to replicate the performance of the benchmark index.
Alternatively, with actively managed funds, investors have access to thematic investing.
Unlike index funds, active investing depends on a fund manager’s ability to pick stocks and deliver 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 countries such as Brazil, Thailand and Colombia. .
Comparison of US (domestic) and international stocks
Even if you’ve chosen to own large U.S. companies exclusively, there’s a good chance you already have some international exposure. In the 21st century, multinational companies derive a significant portion of their revenues from developed and emerging international markets.
By shifting your focus abroad, you can mitigate the risk of what is known as “domestic bias,” or the tendency of investors to hold the majority of their portfolios in domestic assets. The national bias dilutes the benefits of diversification when trends change.
Be aware of historical fluctuations in market leadership, which typically alternate between US and international stocks.
For example, the US market has outperformed international stocks over the past decade, boosted by strong gains in the tech sector. However, until the global financial crisis of 2008, international markets led the way.
With the rapid rise in technological advancements, dependence on supply chain and logistics, and other competing factors that come into play in the global economy, international markets may soon take the lead again.
Risks associated with international ETFs
Like all investments, domestic and international ETFs carry various sets of risks. These risks can be market specific, such as stock valuations. Or it can be macro risks, such as high levels of public debt, which can lead to inflation.
Investments in international equities come with additional sources of volatility. Factors such as limited market regulation, variable accounting practices, political instability and currency fluctuations could dampen stock returns.
However, according to Vanguard research, investors could mitigate some of these risks with the right levels of diversification.
Another risk to consider with international ETFs is the risk of overlapping national weightings. Fund managers often act on market opportunities. Therefore, holdings in specific sectors or regions could be similar in several ETFs.
When selecting an international ETF, pay attention to the main holdings of the fund, as well as the distributions of investments between sectors and regions. The key is to align your investments with the desired asset allocation without being overexposed to one area of the market.
Remember that an area or region can be hot today and quickly fall out of favor.
Getting started: how to buy international ETFs
Depending on your financial goals, asset allocation and risk tolerance, there are different strategies for investing in international stocks. Your level of financial knowledge and your commitment to your investments also play a role.
For most investors, passively managed international ETFs are probably the best option. Designed as a buy and hold strategy, they offer automatic diversification and free investors from the constant monitoring of market developments.
A combination of passive and active managed funds might also make sense for investors with a higher tolerance for risk and volatility.
Once you have determined 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% of your total equity allocation in international stocks and up to 30% of your bond allocation in international bonds to take full advantage 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 determining your comfort level, it’s time to select the type of international ETFs you want to buy.
Find international ETFs that meet your financial needs
There are many ETF selection tools available, including those provided by most brokerage firms. You can filter by factors like geographic region, fees, business performance, assets under management, etc. As you refine your options, the main features to consider are:
- Expense and fee ratios: By default, most ETF providers charge competitive fees. But even at relatively low levels, those fees can add up, so be sure to compare apples to apples and read the fine print.
- Assets under management (AUM): Many investors use this number as a vote of confidence to gauge the engagement of other investors with a particular ETF. In addition to AUM figures, it may be useful to check the longevity of the fund.
- Fund issuer: Brands are powerful. And it’s no different in the ETF space. Some investors feel comfortable investing only in large asset managers, while others see the value of newcomers. Decide what works for you and your financial needs.
- Fund performance: The numbers don’t lie. So, while you do your research, take a look at the short, medium and long term performance of a fund.
- Trade volume: The more liquid a fund, the easier it will be to buy and sell. Watch how the average trading volume compares to similar ETFs.
- Main ETF securities: By law, fund companies must disclose their holdings, which is advantageous for investors as it ensures transparency. It is also helpful to decide whether these investments match your financial goals.
- Fund flow: Many investors follow the flow of capital in and out of funds, often weekly and monthly. All long-term trends in fund flows are valuable because they paint a picture of investor sentiment.
Use the factors above as a guide to discovering your next international ETF.
Limited exposure to foreign stocks can look positive when the US market outperforms. But when global trends change, you might miss out on the potential for higher returns and lower volatility.