How to Choose Foreign ETFs - dummies

By Russell Wild

At present, you have more than 300 global and international ETFs from which to choose. (Global ETFs hold U.S. as well as international stocks; international or foreign ETFs hold purely non-U.S. stocks.) Consider the following half dozen factors when deciding which ones to invest in:

  • What’s the correlation? Certain economies are more closely linked to the U.S. economy than others, and the behavior of their stock markets reflects that. Canada, for example, offers limited diversification. Western Europe offers a bit more. For the least amount of correlation among developed nations, you want Japan (the world’s second-largest stock market) or emerging market nations like Russia, Brazil, India, and China.

  • How large is the home market? Although you can invest in individual countries, it can be risky. Oh, you could slice and dice your portfolio to include 50 or so ETFs that represent individual countries (from Belgium to Austria and Singapore to Spain and, more recently, Vietnam to Poland), but that is going to be an awfully hard portfolio to manage. So why do it?

    Choose large regions in which to invest. (The only exceptions might be Japan and the United Kingdom, which have such large stock markets that they each qualify as a region.)

  • Think style. If you have a large enough portfolio, consider dividing your international holdings into value and growth, large and small, just as you do with your domestic holdings. You can also divvy up your portfolio into global industry groupings. Using both style diversification and sector diversification together can be truly powerful.

  • Consider your risk tolerance. Developed countries (United Kingdom, France, Japan) tend to have less volatile stock markets than do emerging market nations (such as those of Latin America, the Middle East, China, Russia, or India). You want both types of investments in your portfolio, but if you are inclined to invest in one much more than the other, know what you’re getting into.

  • What’s the bounce factor? As with any other kind of investment, you can pretty safely assume that risk and return will have a close relationship over many years. Emerging market ETFs will likely be more volatile but, over the long run, more rewarding than ETFs that track the stock markets of developed nations.

    One caveat: Don’t assume that countries with fast-growing economies will necessarily be the most profitable investments.

  • Look to P/E ratios. How expensive is the stock compared to the earnings you’re buying? The P/E is the stock’s Price-Earnings Ratio. You may ask yourself this question when buying a company stock, and it’s just as valid a question when buying a nation’s or a region’s stocks. In general, a lower P/E ratio is more indicative of promising returns than is a high P/E ratio.

    Using ETFs as our proxies for world markets, we find that the Vanguard Total (U.S.) Stock Market ETF (VTI) currently has a P/E of about 18; the Vanguard European ETF (VGK) has a P/E of about 13; the Vanguard Pacific ETF (VPL) has a P/E of approximately 14; and the Vanguard Emerging Market ETF (VWO) also has a P/E of roughly 14.

    So it seems as if foreign stocks — led by Europe — are currently the “value stocks” of the world.

    You want your portfolio to include U.S., European, Pacific, and emerging market stocks, but if you are going to overweight any particular area, you may want to consider the relative P/E ratios, among other factors.