Investing part of your portfolio outside of your home country and into international stocks is an important part of diversification.
It helps you avoid geopolitical risk associated with having all your funds in just one country, minimizes the impact of localized economic bubbles, and allows you to take advantage of areas of growth across the world.
However, many investors don’t look carefully at the international index funds that they select. They pick a single well-known fund like:
- The Vanguard International Stock Fund
- The TSP International Fund
- Or the iShares MSCI Core EAFE ETF
…and assume it covers their basis.
The problem is, a lot of those common funds are heavily concentrated into just a few countries, and Japan alone makes up 18-25% of their portfolio. This can have a dramatically negative affect over decades.
I put together the following infographic in December 2016 to outline the problem that many portfolios have and a simple way to fix it, and now I’m updating this article with additional discussion and some international stock and ETF ideas for 2017 and into 2018.
Discussion: Market-Cap Weighting
A common issue that index funds have in general is that they are weighted by market capitalization.
What this means is that instead of being equally distributed among the companies in their investing scope, they put more money into the biggest ones. Some people think this is the best approach, while others prefer an equal weighted index.
But while weighting by market capitalization makes decent sense on a domestic basis, it makes a lot less sense when applied internationally. When international indices weight themselves by market capitalization with no other factors, it results in a huge concentration into just two or three countries. This is because they are not just weighted by the market cap of each company, but also by the market cap of each country.
This means that Japan dominates just about every international index except for those that specifically exclude it.
Japan, as good as the country is, is not investor-friendly. And now the country faces population shrinkage. If their stock valuations were incredibly cheap, it could be considered a contrarian play, but in fact, Japan currently has a moderately expensive stock market valuation based on a variety of metrics, based on research by Star Capital.
Although I admit I’d love to travel to Japan, neither significant growth nor value exists in their corporate sector right now.
Plus, Japan has the highest public debt in the world as a percentage of GDP. Higher than Greece, higher than the United States, and higher than any other country:
Japan has a shrinking national population, a stock market that is lower today than it was in 1989, stocks are not cheap, and it has a debt problem.
Despite all this, I’m not necessarily even forecasting which country’s markets will do better than others. That’s not the core point.
I actually expect Japan’s market to do better over the next 30 years compared to the past 30 years, even if they don’t do great, because at least there’s not an enormous asset bubble like there was in the 80’s. And their debt is not as bad as some European countries because at least they control their own currency and can inflate their way out of it.
But with an aging demographic and a shrinking population, they’re simply not poised for growth, and their stocks aren’t cheap.
I’m not advocating investors specifically avoid Japan, and start trying to predict which countries will outperform. Instead, I’m merely pointing out how heavily concentrated many popular international stock index funds are into Japan. It often constitutes a fifth or a quarter of their entire fund.
But is there any particular reason why investors’ money should be 3x more concentrated in Japan than Canada? Or 6x more concentrated in Japan than South Korea? Or 10x more concentrated in Japan than Brazil? Just because Japan is economically the biggest?
There’s simply no good reason for international index funds to be weighted strictly by the economic size of each country. It makes far more sense to broaden and diversify more evenly, so that you’re not so heavily tied to the fate of just one country. Especially a shrinking country.
For international stock funds, I just don’t think strict market capitalization weighting is the best way to go. I certainly don’t want most of my international stocks concentrated into Japan and Europe; I’d rather have broader exposure. That’s the more truly passive approach.
If you invest all your foreign holdings into something like the Vanguard International Stock Index, you’ll be 18% in Japan. If you stick to the popular MSCI EAFE index and all the funds that track it, it’ll be more like 25% in Japan.
In addition, you’ll be heavily invested in continental Europe (France, Germany, Switzerland) which shares interconnected geopolitical risks.
When you add another metric to the equation, though, it change which countries dominate the index. Adding a dividend metric often reduces or eliminates Japan from the running.
So if you split this, and instead put 50% of your international equities into the Vanguard International Stock Index ETF (VXUS), and 50% into the iShares International Select Dividend ETF (IDV), your exposure will be more evenly divided:
Click on the image for a bigger view.
Australia has a growing population, is geographically separate, and supplies China and the rest of Asia with important commodities.
Alternatively, if you put 50% into the Vanguard International Stock Index ETF (VXUS), and 50% into the Vanguard International Dividend Appreciation Stock Index ETF (VIGI), your exposure will look more like this:
Click on the image for a bigger view.
That also helps to move some assets out of Japan and spread them around a bit, especially into Canada and India.
International Stock ETFs for 2017
Choosing the right international stock ETF is a combination of the following:
- Which countries you want exposure to, and in what proportions
- What market-caps you want to include (large, medium, small)
- Any additional metrics you want (growth, dividends, etc)
- Expense ratio: the lower the better, all else being equal
Most large international index funds and ETFs are based on one of two sets of indices:
- The Morgan Stanley Capital International (MSCI) indices
- The Financial Times Stock Exchange (FTSE) indices
Both of them allow a fund to passively track a market at a low cost. But although the MSCI and FTSE indices are similar, they’re not exactly the same. For example, one of the biggest differences between the two right now is that MSCI considers South Korea to be an emerging market, while FTSE has considered it to be a developed market since 2009.
BlackRock, the largest asset manager in the world, which owns the massive iShares brand of ETFs, tends to use MSCI for its international index funds. Vanguard, on the other hand, tends to use FTSE indices for its funds.
Below, I’ll highlight some of the funds that I believe offer the best international exposure at the lowest rates.
Best Broad International Stock ETFs
The Vanguard VXUS ETF follows the FTSE Global All Cap ex US Index, which includes developed and emerging markets.
The iShares one follows the MSCI ACWI ex US Investable Market Index, which also includes developed and emerging markets.
The Schwab one follows the FTSE Developed ex US Index, and doesn’t have emerging markets, so to be balanced you might want to get emerging market exposure from another fund. The cool thing about this ETF is that in addition to beating Vanguard on price (!), you get commission-free trading of it inside a Schwab account. This is one reason why I list Charles Schwab as one of my recommended brokerages on my resources page.
Best Emerging Market ETFs
My only complaint with emerging markets ETFs is that nearly a third of the value is typically invested in China, and another huge chunk is split into Taiwan, India, and in some cases South Korea.
You can buy single-country ETFs from iShares alongside your emerging market ETF, like their Brazil ETF or their Singapore ETF, if you want to broaden your emerging market exposure.
Best International Dividend ETFs
The Vanguard International Dividend Appreciation ETF focuses on companies with fast dividend growth, and the yield is rather low at under 2%.
The Vanguard International High Dividend Yield ETF has different geographic exposure, and has an average yield of about 3%.
My preferred one is the iShares International Select Dividend ETF, which follows the Dow Jones EPAC Select Dividend Index (not a FTSE or MSCI index for a change). I like it because it has a 4%+ yield, and gives my portfolio decent exposure to the UK and Australia, which I want.
My Favorite Way to Invest Globally
In addition to owning international stocks through some of the above-mentioned index funds and ETFs, one of my main vehicles for global investing for seven years now is by owning Brookfield Asset Management and Brookfield Infrastructure Partners.
Brookfield Asset Management (ticker: BAM)
Brookfield Asset Management started in 1899 as a Canadian company that began developing electrical infrastructure in Brazil (or Brasil as it’s spelled in Portuguese). It was originally called “Brascan” as the combination of Brasil and Canada.
Now, almost 120 years later, they’ve expanded into a global manager of real estate and infrastructure, and operate closed-end and private equity funds to allow institutional investors to invest alongside them. They have also spun off four publicly-traded partnerships that individual investors can purchase units of.
Click the image for a larger view.
Most of their assets consist of real estate, infrastructure, and renewable energy. The management team uses a contrarian investing strategy, meaning they buy attractive assets at a significant bargain from troubled businesses and turn them around.
When the global financial crisis struck in 2008 and over-leveraged companies started failing, BAM swooped in and purchased assets from those struggling companies, and refinanced those assets with less debt and lower interest rates due to their own investment-grade structure, and those assets became incredibly profitable as the global economy recovered.
During the 2014-2017 severe Brazil recession, Brookfield once again swooped in and made big investments in Brazil, including buying assets from struggling companies.
By fixing the financing, restructuring the companies they buy, and often replacing management of those companies and bringing in experts from their own team, Brookfield plays an important role in keeping critical assets up and running worldwide.
Occasionally, they sell assets to other companies once they are running at optimal performance, so that they can recycle that capital into buying troubled assets at a value once again, for superior returns.
The management team consists of a bunch of chartered accountants, and they use discounted cash flow analysis for valuation of various assets.
The company has achieved 16% annual returns over the last 20 years due to this smart investment strategy and disciplined focus on fundamentals.
Although they are a company with less than $40 billion in market capitalization, they currently have over $250 billion in assets under management.
They make money in two main ways:
- Direct investments in global real estate and infrastructure
- Investment fees for managing funds for other investors to buy in
By operating highly profitable closed-end funds, private equity, and publicly traded partnerships, and investing their own capital and their investors’ capital into them, they expand their scale and operate profitable assets around the world.
Brookfield Infrastructure Partners (ticker: BIP)
My preferred investing vehicle in the Brookfield umbrella of investments is Brookfield Infrastructure Partners.
The partnership was spun off from BAM in 2008 with them continuing to have the controlling stake, and I took a large position back in 2010 when the global economy was still struggling with the aftermath of the financial crisis, which was my first Brookfield investment. Back then, it was trading at an $11 split-adjusted unit price, and was paying a nearly 7% distribution yield.
They bought assets from struggling companies, and at this point, they owned timberland, ports, and a variety of utility assets. The timberland and ports in particular weren’t doing so well due to the lack of global need for wood (for new housing) and the reduced global trade levels in the aftermath of the recession. But that’s exactly why it was a great investment- the company itself was very well-capitalized, and they bought assets at a major discount so that they would profit during a recovery.
I continued to hold for years as the units tripled in price and paid high distributions. It became such a big part of my portfolio that I decided to sell my stake, and used part of the money to buy BAM and invested into a couple other companies. Now, in 2017, while still holding BAM, I recently invested in BIP once again for the long-haul as well because I want that direct infrastructure exposure once more.
A 2016 report by the worldwide management consulting firm McKinsey & Company found that the world needs $49 trillion in infrastructure spending through 2030. It has been a chronic area of under-investment:
Source: McKinsey & Company
As per the report:
The McKinsey Global Institute finds that the world needs to invest an average of $3.3 trillion annually just to support currently expected rates of growth. Emerging economies will account for some 60 percent of that need.
Here is BIP’s current map of operations:
- Natural gas pipelines, electricity transmission, and toll roads in South America
- Freight rail, ports, and logistics assets in Australia
- Telecommunications towers in Europe and India
- And various other utilities throughout Europe and North America
The reason I like investing in Brookfield is that it’s like buying curated emerging market exposure. They combine the well-capitalized and stable organization of a business headquartered in Toronto and New York with infrastructure assets in both developed and emerging economies that they routinely buy at a discount.
Most of their cash flows are contracted for the long-term, and they build inflation-hedges into most of their contracts. These assets are long-lived cashflow-producing machines, and they pay out 50-70% of their cash to unitholders in the form of distributions while investing the remaining amount into growth.
And not much economic/volume growth is needed to produce great returns:
The partnership currently offers a 4% distribution yield, and expects to grow that distribution at 6-9% per year going forward, which translates into 10-13% annualized returns.
In the past, they’ve beaten their estimates.
Normally it’s not a good idea to to put publicly traded partnerships in a Roth IRA, but Brookfield’s partnerships are an exception.
Unlike most Master Limited Partnerships, they are not particularly tax-efficient, their taxes are confusing due to their global nature, and they most likely will not generate UBTI unless they use their revolving credit facility, which they don’t plan on doing. That makes them fairly safe for a Roth, and even preferred for one.
International stocks have broadly under-performed U.S. equities over the last decade.
At the current time, with U.S. stocks highly valued, there are some great opportunities globally. But investors might want to take a look at their international exposure and see if they are more concentrated into just a few countries than they thought they were.
Consider splitting your international exposure into a normal index fund and a dividend-focused index fund, because that combination will spread your geographic exposure out more evenly. I like to own a few different low-cost global index funds to balance out my international exposure, and invest in Brookfield for curated value-oriented emerging market infrastructure exposure as well.
Currently, emerging markets are cheaper than other stock markets around the world based the price to earnings ratio, the price to book ratio, and a variety of other metrics. They’ve dramatically underpeformed U.S. equities over the last decade, and here’s the chart:
While it’s not impossible, I would be greatly surprised if emerging markets do not give investors good returns over the next decade compared to last decade.
In addition to updating newsletter readers on a regular basis, I’ll update this article from time to time to discuss current issues that affect international stock funds and companies, along with any updates regarding specific areas or investments that I consider attractive.