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Question about global equity funds
Old 10-18-2006, 01:06 AM   #1
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Question about global equity funds

Hello! I'm trying to figure some things out about geographic diversification and getting exposure to global equity, and a friend pointed me to the "gurus" on this forum! Kind of a long post though, so if you don't want to read it, please feel free to move on!

Here's the facts:

I'm 34, US citizen/resident, with some tax deferred/exempt accounts managed at Fidelity. Right now my investments are nearly 100% domestic, except for 5% in an emerging markets bond fund. I've decided that I want to put somewhere between $6000 and $9000 (about 15% of my portfolio) into foreign equity exposure. My accounts can access a large number of Fidelity funds, no-fee "FundsNetwork" funds, and all the ETF's.

I was originally thinking I would put about half of this amount into developed markets and half into emerging/developing markets. I quickly discarded the idea of trying to be a foreign stock picker via ADRs: I don't believe I'm any good at that. My next idea was Fidelity's International index fund - but, unlike nearly all of their other products, it has a $10K minimum investment. That's just too much of my portfolio for my comfort, and as near as I can tell it mostly invests in developed markets.

So I started looking around. I tend to think indexes are a good idea, so I looked at the iShares ETFs. One idea I had was to put half in EFA and half in EEM. EFA reflects the MSCI EAFE (Europe, Asia, Far East) index, and EEM reflects the MSCI Emerging markets fund.

But I found it very difficult to determine the cost of holding positions in these ETFs - i.e., by how much do they underperform their index? And as I looked around, I realized there were a bunch of things I didn't understand about foreign equity. For instance, I understand that some funds are currency-hedged. I'm confused - how is that possible when it's an index of foreign equities? I also don't really want a currency hedge - part of the attractiveness of foreign equity for me is that it's a hedge against inflation/globally falling dollar.

So after I got done thinking about it I have a bunch of questions:

Currency hedge or not?

What are the costs associated with a typical ETF, besides the brokerage commission I'm going to have to pay to buy one? I keep hearing about the MER - what's that stand for?

ETFs have less stringent disclosure than mutual funds, and according to their prospectus don't always have to trade at parity with their NAV - is this something I should worry about? The idea of someone arbitraging my investment makes me nervous.

If my goals above (get 50/50 exposure to developed and developing foreign equity in a 15% fraction of the portfolio) were your goals, what would you do? If those aren't your goals, why not? What did you do instead?

Are the MSCI indexes I picked out good indexes? Most of what you can find on indexes in the media relates to the DJIA and S+P 500. These global indexes aren't written about very much and it's not clear to me that things that are true about the S+P 500 indexes are clearly true about global indexes. Do the foreign indexes change a lot? (How stable can an "emerging markets index" be, after all?) Should I be looking instead at actively managed international funds? Some of them have beat the pants off the indices (namely the Artisan International Value fund, and the Janus Overseas; those are just two that I happen to have read the prospectuses of, I am not trying to tout them.)

What else should I know about this topic that I failed to ask about?

Thanks in advance for your time and your wisdom!
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Re: Question about global equity funds
Old 10-18-2006, 05:29 AM   #2
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Re: Question about global equity funds

Hi Eagle.. welcome to the forum.. I've been thinking about this issue, too, but not in the depth that you have.. I found a short article here: http://www.safehaven.com/article-4012.htm that graphically portrays some of the currency concerns w/r/t foreign market ETFs. The problem is that for US investors there isn't really the currency hedging function one would think there would be.

Currency hedging (which to you sounds like a bad thing) is actually of the essence. If you look at it in terms of the interior of a foreign fund or ETF, you can imagine that a fund that tries to mirror the overall performance of the MSCI EAFE will necessarily have to juggle the values of holdings in the dozens of different home currencies: yen, baht, yuan, euros and so on, and keep the whole in line with the overall EAFE index, its stated benchmark. In the case of ETFs, 'arbitraging' actually helps keeps the pricing in line, as it does in many other arenas. It IS mind-boggling, though!

If the ETF is true to its mandate, as it were, then its performance should be off the index by the amount of its declared expense ratio (ER) otherwise known as management expense ratio (MER). Go to the sponsor's web site (i.e., Barclay's iShares) for this figure. An ETF will likely have a slightly lower ER than almost all index funds, and definitely a lower ER than actively managed funds.

The ETFs can vary in price from NAV because of the laws of supply and demand.. When you go to Fidelity, they say "here is our fund price; buy it or don't".. on the 'open' market there is extra room for negotiation, as it were.. where people's ideas about where the collective holdings are going come into play just like for any individual stock. This is ON TOP OF any speculation inherent (taken stock-by-stock, or bond-by-bond) in the NAV price for a fund.

The advantages of an ETF tracking an index over a similar Fidelity index fund are:
1. no investment minimum
2. cheaper trading cost if you are buying from a regular discount brokerage (you'll pay a ~$50 xaction fee for each fund purchase, from Vanguard, say.. not sure if Fidelity funds are even available outside Fidelity)
3. probable slightly lower expense ratio
4. you can play stock games like options, short selling, stop loss and limit orders.. (that stuff I don't get into)

The advantage of the Fidelity index fund (buying from inside Fidelity)
1. No transaction costs (I believe) if you are doing a DCA and purchasing small amounts month by month.

This is how I understand one small slice of the admittedly complex ETF/international investing universe. Please feel free, anyone, to correct any mis-information I may have given regarding Fidelity (or anything else, for that matter); I have no experience with how their investment services work.

That said, if you were willing to put $6-$9k into a Fidelity index fund, I personally don't see a big difference between $9k and $10k, and on the basis of that alone I would take the plunge, IF you like the fund's mix. I think your instinct about spreading out between a fund/ETF that covers the developed world and one that targets emerging markets is sound.. now take a look and see whether the one-stop-shopping of the Fidelity International Index also gives you the level of emerging mkt. exposure you would like.

The US represents 45-50% of the world's market capitalization.. the other 50-55% is international. The case for increased international investing is valid, as these markets grow and mature.. In hindsight, for me, the international stocks I have are the ones that've been pulling the wagon. In the future, who knows? And who knows how much the international markets will react in kind if/when the US economy has a rough landing...

..didn't expect this to be so long, either, but..
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Re: Question about global equity funds
Old 10-18-2006, 01:45 PM   #3
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Re: Question about global equity funds

Quote:
Originally Posted by Eagle
My next idea was Fidelity's International index fund - but, unlike nearly all of their other products, it has a $10K minimum investment. That's just too much of my portfolio for my comfort, and as near as I can tell it mostly invests in developed markets.
I'm not going to try to change your mind, but you might want to revisit this decision when the difference between $9000 and $10,000 is less critical to your comfort level. There's nothing wrong with dividend-paying developed markets, especially when emerging markets have way more volatility than the $1000 that makes you uncomfortable.

Quote:
Originally Posted by Eagle
So I started looking around. I tend to think indexes are a good idea, so I looked at the iShares ETFs. One idea I had was to put half in EFA and half in EEM. EFA reflects the MSCI EAFE (Europe, Asia, Far East) index, and EEM reflects the MSCI Emerging markets fund.
Nothing wrong with that either. You're setting an asset allocation that you feel comfortable with, and presumably rebalancing it when it gets too far out of balance.

Quote:
Originally Posted by Eagle
But I found it very difficult to determine the cost of holding positions in these ETFs - i.e., by how much do they underperform their index?
A well-developed index fund will generally underperform the index by its costs. That has some caveats-- a fund's version of the index will occasionally deviate by what's euphemistically called "tracking error" and Vanguard's Gus Sauter tends to be pretty good at creating positive ones. Variations occur because most funds (ETFs, mutuals, whatever) don't precisely replicate the index but rather try to simulate it via various quantitative or qualitative means. They also drop & add stocks whenever they feel they need to. That's why it can be difficult to determine precisely what they're holding.

Quote:
Originally Posted by Eagle
For instance, I understand that some funds are currency-hedged. I'm confused - how is that possible when it's an index of foreign equities? I also don't really want a currency hedge - part of the attractiveness of foreign equity for me is that it's a hedge against inflation/globally falling dollar.
Currency hedge or not?
The fund managers spend American dollars to buy foreign stocks. They're probably holding ADRs or buying the stocks directly to create the fund shares. As the dollar's value fluctuates against the currency of the stock's country, the share value of the stock also fluctuates in the opposite direction. So if the dollar goes "down", the value (in dollars) of that foreign stock goes up. (Your currency is worth less so your stock costs more units of that currency.) This is great if you bought the stock with last year's dollar, but it sucks if you're buying the stock with next week's paycheck.

Fund managers know that their customers hate downward volatility, so some of them reduce currency volatility by paying for foreign-currency contracts (promising to buy xx amount of currency at a future date for yy $$) that move in the opposite direction of the dollar. In other words they're trading currency options to flatten out the currency fluctuations. Of course this isn't cheap-- the Powershares International Dividend unhedged ETF (PID) has an annual expense ratio of 0.6% while Tweedy, Browne Global Value (totally hedged) mutual fund (TBGVX) has an ER of 1.38%.

The irony of hedging is that it's just to make the customers feel better. Tweedy's own literature admits that currency fluctuations settle out over a 20-year period. (The American dollar used to be hugely strong against European currencies in the 1980s.) So Tweedy shareholders are paying at least 0.78% per year to minimize short-term fluctuations around a long-term zero. We don't care about currency hedging any more, and that's why we're moving from TBGVX to PID.

Quote:
Originally Posted by Eagle
What are the costs associated with a typical ETF, besides the brokerage commission I'm going to have to pay to buy one? I keep hearing about the MER - what's that stand for?
"Management Expense Ratio"-- see http://www.investopedia.com/terms/e/expenseratio.asp. International ETF annual ERs vary from about 0.2% to 0.8% but could be over 1% in some niches. That annual expense ratio reduces the ETF's NAV, which is roughly its share price.

If you hold an international ETF, other typical costs are the taxes you may have to pay on cap gains/dividend distributions (if there are distributions). After the tax year ends you'll get a 1099-DIV and other brokerage statements showing those numbers.

International funds also pay taxes in foreign countries, and those may be deductible on American taxes.

If you sell an ETF instead of holding it then you may be paying cap gains taxes.

Quote:
Originally Posted by Eagle
ETFs have less stringent disclosure than mutual funds, and according to their prospectus don't always have to trade at parity with their NAV - is this something I should worry about? The idea of someone arbitraging my investment makes me nervous.
Not usually. If you're a long-term holder (years or decades) then you won't see the effect of the ARBs.

One advantage of ETFs is that they can create or destroy shares at will by converting the shares into their underlying stocks. (This is what the arbs try to do.) Your money is always fully invested. Mutual funds can't immediately put your deposit to work and may not even put your money where their prospectus says they'll try to put it. If everyone throws money at an actively-managed mutual fund, the eventual bloat eats away at its performance goals.

The drawback of ETFs is that they're always on sale for a bid-ask spread and they may occasionally trade at a few cents above or below NAV. This is usually not considered significant, and if you're not trading then it's not an issue.

Quote:
Originally Posted by Eagle
If my goals above (get 50/50 exposure to developed and developing foreign equity in a 15% fraction of the portfolio) were your goals, what would you do? If those aren't your goals, why not? What did you do instead?
If we had your goals then I'd do what you're proposing-- put half of my money in EFA and the other half in EEM and stop worrying about it.

Our goals are different-- we have a high-equity portfolio and we want more international exposure. Getting back to your disclosure issue, foreign stocks have much looser disclosure requirements than American stocks (especially now that Sarbanes-Oxley legislation is driving a lot of foreign stocks away from American exchanges). One of the better indicators of a stock's health is its ability to pay dividends, so we like the Mergent's International Dividend Achievers index. The Powershares International Dividend ETF attempts to replicate that index, so we've been selling off our Tweedy shares and putting the money in PID shares. Our total international asset allocation is about 30% of our early retirement portfolio, spread among IRAs and after-tax accounts.

Quote:
Originally Posted by Eagle
Are the MSCI indexes I picked out good indexes? Most of what you can find on indexes in the media relates to the DJIA and S+P 500. These global indexes aren't written about very much and it's not clear to me that things that are true about the S+P 500 indexes are clearly true about global indexes. Do the foreign indexes change a lot? (How stable can an "emerging markets index" be, after all?) Should I be looking instead at actively managed international funds? Some of them have beat the pants off the indices (namely the Artisan International Value fund, and the Janus Overseas; those are just two that I happen to have read the prospectuses of, I am not trying to tout them.)
The MSCIs are pretty popular, but one chronic complaint has been that the EAFE over-emphasizes Japan. There are plenty of MSCI indexes that are ex-Japan or focused on other countries.

I think that the indices turn over much less than the actively-managed funds and probably even less than the S&P500. If you want to reduce turnover to zero then you'd probably have to pick your own stocks/ADRs. That'd also reduce your annual expenses to zero if you held the shares, but you'd have to do your own work to find the stocks and buy them. (For example, you could just buy whatever's in the Mergent's International Dividend Achievers index.) ETFs seem to be an acceptable compromise.

You could try an actively-managed fund but you'll pay more for it. Active managers have higher turnover so they have higher transaction costs and pay more taxes. You'll pay a higher expense ratio than an equivalent ETF and you'll pay it whether your active manager exceeds the market or lags it. The difficulty is determining whether your active manager is about to exceed or lag, and for how long.

We like PID's low turnover and its lower expense ratio, but we're reinvesting dividends (which is done for free by Fidelity's brokerage account) and we're planning to hold the shares for a couple decades. IMO that long-term horizon beats the pants off active management.

Quote:
Originally Posted by Eagle
What else should I know about this topic that I failed to ask about?
Although we're kicking Tweedy to the curb after 10 years, they have a great investor's library at http://www.tweedy.com/content.asp?pageref=reports. I'd read through those papers & reports.
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