There are ETFs that you can use to implement the quarterly international equity momentum strategy in place of the benchmarks mentioned earlier, as follows:
1. iShares MSCI Emerging Market Index ETF (ticker symbol
EEM).
2. iShares MSCI Japan Index ETF (ticker symbol EWJ) in place
of the MSCI Far East Index.
3. iShares Europe 350 Index ETF (ticker symbol IEV) in place of
the MSCI Europe Index.
The expense ratios of these ETFs range from 0.54%–0.75%. In addition to a mutual fund’s or ETF’s expenses, American investors lose out to withholding taxes that foreign countries levy on dividends paid to foreign investors. (The U.S. likewise withholds 30% of stock dividends paid to foreign investors in American stocks.) Stock transfer taxes can also be significant. For example, in May 2007, the Chinese government tripled its stock transfer tax from 0.1% to 0.3%. These taxes have taken
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an extra 0.6%/year off of the returns you would otherwise have gotten from holding European stocks. The impact of withholding taxes on emerging market returns has been 0.4%/year, but the impact on stocks
in the Far East Index (mostly Japanese) has been only 0.1%/year.7 The
performance of the ETFs in real time (including distributions) will reflect foreign tax withholding. However the historical index data used in this chapter did not take foreign or U.S. taxes into account.
Conclusion
Although the United States has the most important stock market in the world, American equities represent less than half of global equity capital. Western European stock markets are the next largest group. European stocks by and large fluctuate in parallel with U.S. markets. As a result, they may be sources of added profit (compared to an all-U.S. portfolio) but are not likely to help reduce risk.
Asian stock markets have been less tightly correlated to U.S. mar- kets than have European stocks. Asian economies and stock markets had their share of turbulence in the 1990s, but since 2003, Asia has been the epicenter of world economic growth, and its stock markets have climbed accordingly, growing far faster than U.S. stocks since 2003.
Emerging market countries are those whose economies are developing. Although this is a diverse group of countries, as a whole their stock markets have not been highly correlated with the move- ments of our own market (which is an advantage when constructing a diversified portfolio). Instead, emerging market stocks have been closely correlated with commodity prices.
A diversified international portfolio would include all of these regions. The easiest way to gain exposure is through high-quality mutual funds. We have recommended the following:
• First Eagle Global (SGENX)
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• DWS Global Thematic (SCOBX) • New World Fund (NEWFX)
If you are able to purchase these funds without paying a sales commission, then a portfolio comprised of this group of funds could offer a superior balance between risk and reward if past patterns repeat themselves (which is unfortunately not guaranteed). Remember, do not buy class B or C shares, and do not pay a sales load. Of the four funds, New World and DWS Global Thematic should be considered relatively aggressive, while the other two funds were less risky than the overall international market during the 2000–2003 bear market.
Those of you willing to calculate the performance of three inter- national equity ETFs each quarter and make quarterly changes to your holdings (if necessary) might be able to increase your potential gains by selecting the ETF that had the best gains during the previous three months. That ETF becomes your selection for the upcoming quarter. At the end of every calendar quarter, you repeat your evalua- tion and place your capital into whichever region was best in the prior quarter. The ETFs with which to implement this strategy are the following:
• iShares Europe 350 Index ETF (IEV) • iShares MSCI Japan Index ETF (EWJ)
• iShares MSCI Emerging Markets Index ETF (EEM)
We will close the chapter with a comment on whether you should adopt the active approach of selecting the best ETF, or the more pas- sive approach of holding mutual funds for the long term, hoping that they will continue to outperform their benchmarks in the future. Philo- sophically, we prefer the strategy of selecting the best international ETF each quarter because the rules to implement the strategy are objective and the motivation of following the prevailing major trend is easy to understand. Moreover, it is appealing to have a system by which to increase your exposure to the ETF that is performing best and to avoid any exposure to the weaker ones, as opposed to the passive
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strategy of maintaining a fixed allocation to a mutual fund even when its manager’s investment strategies may be lagging. Although the international funds we have recommended have done very well compared to their peers, especially from 2000–2007, none of us knows how long the currently successful management teams will remain in place, or how the funds will fare the next time the market climate changes. If you can spare the effort, it seems more attractive to utilize a strategy that adjusts your portfolio so that your investments are in the optimal selections for whatever the market may be doing at the time.
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