From the April 2007 issue of Research Magazine • Subscribe!

Is Your Portfolio Bilingual?

Harvard University's rich (and closely watched) endowment continues to capture stellar returns.

The $29.2 billion Harvard investment portfolio earned an annualized 10-year performance of 15.2 percent through mid-2006. That was 6.5 percentage points better than the median large institutional fund, as measured by the Trust Universe Comparison Service (TUCS).

What explains such strong performance? Simply put, Harvard's endowment has maintained especially generous exposure to areas where it's experienced its best gains: commodities, real estate and foreign stocks. The last asset class in particular points to the important contribution that non-domestic equities from both developed and emerging market economies have made to Harvard's good fortune and the portfolios of other investors as well.

Are your clients' portfolios "bilingual" in the sense that they bridge the gap between the U.S. economy and opportunities overseas? If not, it may be time to revisit their asset allocation. In addition to the potential that emerging markets will continue to generate strong gains, a portfolio's risk and volatility can be reduced when foreign stocks are added to an already-diversified mix of dollar-denominated stocks and bonds.

"A second reason to add international stocks is that they are valued in native currency, which hedges investors against devaluation of the U.S. dollar," states Richard A. Ferri, CFA, and founder of Portfolio Solutions. Indeed, international markets over the past several years have been boosted both by their own strong equity prices and by a weakening U.S. dollar. As a result, U.S. investors who were underweighted or lacked any exposure to international markets at all have done themselves a great disservice.

Back in the 1980s, Harvard's endowment had a mix of investments that consisted principally of domestic stocks and bonds. Had the university continued on that course, it would have reaped returns well below the endowment's financial goals. Mohamed A. El-Erian, who was named Harvard Management Company president and CEO in October 2005, has noted that the endowment has for more than a decade been much more broadly invested; today, he indicated, about 40 percent of its assets are "non-U.S." holdings.

Summing up the fund's most recent performance, El-Erian observed that Harvard had been well served by its campaign to progressively diversify and internationalize its endowment assets. Financial advisors can provide their clients the same diversification benefits by incorporating international and emerging market exposure from the diverse menu of exchange-traded funds (ETFs). During the first quarter of 2007, this menu contained a host of possibilities: 73 broad-based "international" ETFs and another 10 vehicles specializing in emerging market stocks.

Spinning The Globe

The iShares family of ETFs from Barclays Global Investors offers both growth and value style-focused versions of the widely-tracked MSCI EAFE index. In 2006, the iShares MSCI EAFE Value (NYSE: EFV) gained 29.16 percent, edging out the MSCI EAFE Growth (NYSE: EFG), which increased just 21.88 percent. Both funds have been helped by soaring foreign stock prices and charge modest expense ratios of 0.40 percent apiece.

Last year, New York City-based WisdomTree Investments launched a series of fundamentally dividend-weighted international ETFs. These funds offer both broad and concentrated exposure to international stocks, always with a dividend tilt.

The WisdomTree DIEFA (NYSE: DWM) is based on its eponymous fundamentally weighted DIEFA (Dividend Index of Europe, Far East Asia and Australasia) index, which in turn measures the performance of dividend-paying companies in the industrialized world (excluding Canada and the United States) that both pay regular cash dividends and meet assorted liquidity and capitalization requirements. Constituents are drawn from the universe of companies incorporated in 16 developed European countries, Japan, Australia, New Zealand, Hong Kong and Singapore. Once added to the index, companies are weighted according to the annual cash dividends they pay. The fund charges an expense ratio of 0.48 percent.

For a more regionally concentrated approach, the WisdomTree Europe Dividend (NYSE: DEB) fund is based on a fundamentally weighted index that measures the performance of those companies in the WisdomTree DIEFA index that pay regular cash dividends, meet the liquidity and capitalization requirements and, most significantly, are incorporated in developed Europe. Again, companies are weighted in the Europe-only index based on annual cash dividends paid. Top holdings include HSBC Holdings, Royal Bank of Scotland Group, and Vodafone Group.

Another interesting opportunity is the SPDR MSCI ACWI ex-US ETF (Amex: CWI), an offering from State Street Global Advisors. One factor that's unique to this fund is that it conveniently blends exposure to both developed and emerging market stocks, all in one package. As I write this, approximately 80 percent of the portfolio is invested in developed international markets; the remaining 20 percent is in emerging markets. On a country-by-country basis, the United Kingdom and Japan, as the two largest non-U.S. markets, are the largest positions with the fund allocating roughly 20 percent of its assets to each. Canada, France, Germany and Switzerland each account for roughly 5 percent positions. Hong Kong, South Korea and Taiwan are the top emerging markets represented.

Emerging Markets

Speaking of emerging markets, one of the best values in emerging market funds continues to be the Vanguard Emerging Market ETF (AMEX: VWO). The fund is currently invested in over 700 stocks in 23 countries (including significant market exposure to mega-developing countries such as China, India and Russia) and returned a healthy 29.02 percent to investors in 2006. Despite its broad focus, the fund also carries a relatively low expense ratio of just 0.30 percent.

Claymore Securities recently launched its own emerging markets fund, BNY BRIC (AMEX: EEB). The fund offers concentrated exposure to four of the largest emerging economies in the world: Brazil, China, India and Russia. With regard to country weightings, Brazil had the greatest representation at the end of 2006, accounting for 45.88 percent of the index. China was next with 35.79 percent, while Indian and Russian shares accounted for 13.56 percent and 4.77 percent of the portfolio, respectively.

Investors looking for narrower exposure for a particular market -- emerging or developed -- may be tempted by a number of exchange-traded products that have emerged over the last few years. Just in the Pacific Rim alone, the opportunities are numerous.

Like other WisdomTree ETFs, the WisdomTree Japan Dividend ETF (NYSE: DXJ) is based on a fundamentally weighted index that measures the performance of dividend-paying companies; This one considers only companies that meet all the requirements to be included in the WisdomTree DIEFA Index and are both incorporated in Japan and traded on the Tokyo Stock Exchange. Once again, companies are weighted in the portfolio based on the annual cash dividends they pay out.

Back in the iShares arena, the iShares MSCI Australia Index Fund (NYSE: EWA) has been on a tear, reporting a stellar 24.55 percent annualized return over the five-year period through the end of 2006. The fund has basked in its exposure to some of Australia's best-known companies, including BHP Billiton, National Australia Bank, Westpac Banking Corp. and Westfield Group. In terms of sector exposure, banks accounted for 24.76 percent of the overall portfolio, while 15.19 percent of the ETF's assets were in metals and mining shares. Real estate rounded out the top three, with a weighting of 10.04 percent.

The iShares MSCI Malaysia Index Fund (NYSE: EWM) gained 36.20 percent in 2006 and has started 2007 in similar style, registering double-digit year-to-date gains by mid-February. Top sector weightings include banks (24.02 percent), hotels and leisure (10.79 percent) and electric utilities (5.08 percent).

Conclusion

When constructing a portfolio with international and emerging market ETFs, remember a few things. Choose wisely, keep your expense ratios low and don't overdose on too much of a good thing.

And one more thing: Being bilingual is good!

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Ron DeLegge is the editor of www.etfguide.com.

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