Index-fund investing, a well-established practice in domestic markets, is rapidly gaining fans among investors fishing in foreign waters.
Traditionally, most small investors have opted for actively managed mutual funds as a springboard for entering global markets. In the past year, however, index funds, notably exchange-traded funds or ETFs, have climbed into the spotlight with their strong performance, cost efficiency, and a widening investor appreciation of their precision as asset-allocation vehicles. Assets of ETFs with a foreign focus have doubled in the last year and now approach $50 billion - almost 20 percent of the money garnered by ETFs of all kinds, according to the Investment Company Institute.
ETFs are perhaps best viewed as mutual funds that can be traded daily, like stocks. The shares represent a basket of securities, but unlike mutual funds they are priced every 15 seconds on a major stock exchange, rather than once a day. As underlying securities in the basket fluctuate in value, so does the net asset value of the ETF. Buying and selling an ETF also involves paying a commission. "Investors are increasingly looking to ETFs to fulfill their international diversification needs," says Lisa Chen, senior international portfolio manager at Barclays Global Investors. Barclays, the leading player in international ETFs, sponsors a family of 35 iShares funds covering the Pacific, Europe, and Latin America as well as country-specific funds for Malaysia, Taiwan, South Korea, and others.
Barclays's bellwether international ETF, the iShares MSCI EAFE Index fund with some $20 billion in assets, is now the second-largest ETF behind the older SPDR 500 Trust, commonly called "Spider," which tracks the S&P 500 index.
ETFs offer a way for investors to track a benchmark index at low cost and with a higher degree of trading flexibility than that of a standard mutual fund, says Daniel Culloton, a senior analyst at Morningstar, Inc.
Growing recognition that the majority of actively managed mutual funds generally lag behind their benchmark indices is a key factor spurring enthusiasm for the passive approach represented by ETFs, experts say.
"You can make as compelling a case for indexing in international markets as you can in the US market," says George Sauter, chief investment officer at the Vanguard Group. Whether you invest in a traditional index fund or an exchange-traded product, passively managed funds offer predictability - the assurance that the fund will mimic the performance of a benchmark index. This is important to investors with diversified portfolios spread among five or more asset classes, he notes.
Lower costs also give index funds an edge with respect to investing overseas, where active managers must often do extensive legwork in researching stocks. The average expense ratio of actively managed international funds, for example, is 1.77 percent, according to Morningstar, while Vanguard's largest foreign index fund has a paltry 0.31 percent expense ratio.
That said, low expenses are probably less significant than strong performance in attracting investors to international ETFs. For the past three years, most ETFs with a foreign focus have handily outperformed the average domestic equity fund. Emerging-market ETFs, in particular, have been on a roll with annualized returns over the past three years in excess of 25 percent in local currency and more than 30 percent in dollar terms. The favorable trend has persisted despite the fact that the dollar has appreciated against the Euro and yen during most of 2005.
"With ETFs you can pick the most attractive markets around the globe, know exactly what's inside the basket of stocks you own, and maintain control over the portfolio," says Brian Orol, president of Strategic Financial Planning Group LLC, in Raleigh N.C. Mr. Orol particularly likes the fact that ETFs allow investors to set limit and stop orders, enabling them to quickly enter or exit a position at predetermined price points.