After 1995 these anti-indexing arguments are starting to look like bunk, thanks to the fact that there are enough foreign funds with five- and 10-year records to test the hypothesis. Result: foreign indexes handily beat most fund managers in three out of four international categories. The longer the time period measured, the better the indexes did. “Indexing may be much more powerful internationally than we thought,” says Andrew Lohmeier, an analyst at Morningstar.
It shouldn’t be a particularly shocking revelation, but it is because many experts have maintained that index investing’s key strengths would be drawbacks in foreign markets. Consider an index fund’s autopilot investment style. It typically holds a broad sampler of stocks, rarely adding or jettisoning a name. In the United States, this market-in-miniature approach has worked well because there are few hidden nuggets of value to uncover. But in foreign markets, the opposite was supposed to be true. “Portfolio managers argue that many of the best investment opportunities are emerging companies that aren’t included in foreign indexes,” says Lawrence Lieberman, an executive at fund consultant Wadsworth & Associates in New York City. But guess what? None of the fund managers who’ve been plumbing the emerging markets for those gems during the last five years has been able to beat the Morgan Stanley Capital International’s Emerging Markets Global index.
There are other differences that give foreign index funds a big advantage over portfolio managers. Extremely low costs, which provide an edge here, lend an even bigger helping hand abroad. Why? Fund companies really jack up the expenses they charge you for a foreign fund. The reason: it costs more to trade and research stocks abroad. Foreign funds’ average expense ratio is 1.76 percent, according to Morningstar. But because they don’t trade much, foreign index funds charge far less. The expense ratio for Vanguard’s European and Pacific index funds: just .32 percent. That means an index fund can start passing along its earnings to shareholders while an actively managed fund is still covering its expenses. Moreover, almost no index funds charge you for admission. But many foreign funds do. Fidelity Advisor Overseas A has a five-year return of 9.81 percent, better than the index’s 9.37 gain. But if you adjust for the sales charge, the fund loses out to the index, with a 9.03 percent return.
The biggest surprise in the indexes’ strong overseas showing is that they didn’t trip on a currency mine field. Index funds don’t hedge, or protect themselves, against currency movements, so they’re especially vulnerable to downdrafts like the Mexican peso’s ruinous 1994 devaluation. But the truth is, most fund managers don’t hedge against currencies, either. It’s expensive, and it’s guesswork. And, more important, it doesn’t boost long-term returns. “Whether managers hedge fully, or don’t hedge at all, most currency movements wash out over the long run,” says Lohmeier.
Not all index funds take home blue ribbons. The strategy failed in the Pacific. And the reason was plainly Japan, whose stock market has been a disaster area for years. Fund managers could steer their portfolios away from the meltdown, but Pacific index funds couldn’t. The index mustered only an average 7.4 percent gain over the last five years, against 9.1 percent for actively managed funds, after expenses and sales charges.
While foreign indexing is a good bet, there are some pitfalls. Stay away from funds that are heavily dominated by a single country. Also beware of funds that are too narrowly focused on a few countries-or on a kind of stock. Also be prepared for some dizzying moments. Foreign index funds tend to be more volatile than managed funds.
But don’t let these caveats send you running. International indexing clearly deserves a flesh review from investors. Here’s a guide:
Developed countries. Morgan Stanley’s EAFE (for Europe, Australia and Far East) is the index against which most diver-sifted international funds measure themselves. Skeptics have bad-mouthed the idea of investing in an EAFE-based index fund because it’s loaded with Japanese stocks. But despite that heavy freight, EAFE has managed to nose ahead of 60 actively managed funds’ average load-adjusted return over the last five years. Now that Japan’s market looks like it’s bottoming out, EAFE may be an especially good wager. MainStay Institutional EAFE Index, the oldest fund, has tracked the gauge reasonably well, but its expense ratio is 1.26 percentage points–too high. A better choice: combine Vanguard’s International Equity European and International Equity Pacific funds to create an EAFE index fund with an expense ratio of just .32 of a percentage point. Vanguard (800-662-7447) will tell you the correct proportions.
Europe. Here’s the quandary: the MSCI Europe index trounced 85 percent of comparable actively managed funds during the last five years, but it’s a narrow way to play the index game because it’s one region. If you like Europe’s prospects, though, you’ll love Vanguard’s European fund and DF32s Continental Small Co. Both beat the index’s five-year numbers.
Emerging markets. Contrary to what almost everybody expected, the MSCI Emerging Markets index has beat all three emerging-market funds with five-year records. Chalk it up to being fully invested and diverse-there are 28 countries in the index. Unfortunately, there’s only one emerging-market fund, Vanguard’s, and it has only a one-year record. Still, it may be the answer for investors leery of these volatile bourses. Vanguard edited the index by vanquishing countries where stocks are hard to trade or the market is stacked against foreign owners. Result: while the index plummeted 10.76 percent last year, Vanguard’s fund eked out a .46 percent return.
Pacific. Diversification is one reason index investing works so well, but this region can’t easily achieve it. Keep Japan in the index, and it overwhelms the other countries with an 80 percent weighting. Take it out, and you’re missing the Pacific Rim economy’s main engine. Fans of this part of the world may do better with an actively managed fund such as Nomura Pacific Basin or Merrill Lynch Pacific A.
Fund companies have spent a lot of money convincing us that we shouldn’t venture abroad without high-priced talent pointing the way. Maybe it’s finally time to read the signposts ourselves: fancy salaries don’t always provide the best returns.
Over various time periods, the global indexes produced higher average returns than managed foreign stock funds. MANAGED GLOBAL MUTUAL FUNDS MORGAN STANLEY AVERAGE 10-YEARS STOCK INDEX RETURN[*] 10-YEAR RETURN Foreign 11.9% 13.62% European 8.9[b] 11.63[b] Emerging markets 11.68[b] 13.81[b] Pacific 13.8 13.6
