Solving the International-Asset Puzzle: Portfolio Fix

Experts suggest three funds, but say that an investor's time horizon is the most critical issue.

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International investing has been the subject of much discussion over the past few years. Yet the issues of what and how much to own only seem to get more puzzling for investors.

With growth in emerging markets like China and India far outpacing that of developed nations in North America and Europe, international markets have offered a compelling investment thesis that’s been backed up by strong historical performance in recent years.

When the domestic housing market collapsed in 2008, sending the U.S. dollar plummeting and the economy into recession, the steady stream of inflows to international mutual and exchange traded funds – particularly emerging market funds – turned into a flood.

Still, the very thing that drew investors to international markets in the first place – stronger growth – is now the cause of their underperformance in 2011.

Worried that their blazing growth will cause a spike in inflation, policymakers in China, India, Brazil, and elsewhere have moved to raise interest rates, and – in Brazil’s case – even levied a tax on new foreign investment. This has dimmed their attraction as investment destinations, and led to significant underperformance in the first half of the year.

For those wondering whether to keep, sell, or buy more of the many international funds and ETFs that have appeared in recent years, Standard and Poor’s International Equity Strategist Alec Young says the issue mostly comes down to an investor’s desired time horizon.

Domestic stocks generally should generally outperform international equities over the remainder of 2011 and into 2012, Young says. However, he recommends investors keep 15% of their portfolio in international equities, with 5% in emerging markets. “You have to be very surgical” when it comes to the international assets, he says.  

Young has three specific recommendations for investors when reviewing their international allocations.

For those who want yield and some stability while maintaining geographical diversification, he recommends “European non-bank multinationals with big emerging market sales footprints,” particularly in less cyclical sectors such as consumer staples. They pay fatter dividends than U.S. companies and offer cheap exposure to emerging markets without being dragged down by Europe’s weak economy.

In addition, short-term emerging-market bond funds denominated in local currencies are a good way to benefit from a weak U.S. dollar and are less exposed to inflation and interest rate risk.

For those with a longer-term outlook and more stomach for risk, Young suggests broadly diversified emerging-market funds. While some of these funds have taken a hit recently, that’s more of a reason to get in now, he says: “You want to be buying when they’re down.”

Using S&P’s mutual fund and ETF screens, we found three funds that could be used to implement Young’s recommendations.

For those seeking stability and income, one fund that fits the bill of owning large, European non-bank multinationals is the Manning & Napier International Series, which has more than half its assets in European companies and a relatively small allocation to the financial sector. Its low expense ratio and strong long term track record – a 10-year average annual return of 8.2% – are also appealing.

Financials accounted for less than 12% of the fund as of March 31, while its largest sector allocation was consumer staples. Its three largest holdings were Siemens, Brazilian dental care provider Odontoprev, and Unilever.

The growth in investor demand for international diversification has led to the creation of no less than 13 international bond ETFs in the past four years. While there are even more international bond mutual funds, they often charge a sales load and stiff annual fees.

One attractive choice is the WisdomTree Emerging Markets Local Debt ETF, which has one of the lowest portfolio durations at 3.71 as of June 8 and an attractive yield of about 4.8%. Its $872 million in assets are mostly invested in investment-grade bonds from Mexico, Brazil, Indonesia and Malaysia.

For a broadly diversified emerging markets fund, it would be hard to top Vanguard’s MSCI Emerging Markets ETF. Such is its popularity that it is the second largest equity ETF listed in the U.S. with $65.3 billion in assets as of April 30.

The ETF owns a massive 896 different issues, with the 10 largest representing just 18% of the fund. Its three largest holdings in late April were Brazil’s state oil company Petrobras, Samsung Electronics and Brazilian steelmaker Vale. 

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