Should You Invest in Specific Countries or International Funds?

Differences Between Active and Passive Investing

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Most international investors would agree that exchange-traded funds (“ETFs”) are the easiest way to invest in equities and bonds. But, investors still have a choice between investing in a country, regional, or international ETFs when looking abroad. Active investors may prefer to use country ETFs in order to pick top performers around the world, while passive investors may prefer broad market international ETFs as a way to build a fully diversified portfolio.

In this article, we will take a look at the pros and cons of each approach and help investors make the right decision for their portfolios.

Active Investing With Country ETFs

Country ETFs enable active investors to build a highly customized portfolio. For example, an investor may be confident that an incoming president will turnaround a nation’s economy and decide to purchase that country’s ETF to capitalize on it. This approach is similar to traditional active investing in many ways, where an investor will purchase an individual company’s stock because it appears undervalued compared to the rest of the market.

The benefit of this approach is that investors can target specific countries that they believe have the greatest potential upside. On the other hand, investors can actively avoid countries that they believe will do poorly and hold positions in others. This kind of flexibility could improve returns of control risks depending on the investor’s goals, although successfully executing these strategies requires more skill than passive investing.

The biggest downside of this approach is the growing body of research showing that active investors tend to underperform passive investors. According to the Wharton School of Business, professional managers of stock funds produced lower returns than their index competitors 97% of the time, while the few that outperformed were still likely to underperform in the future.

Investors may want to exercise caution when using this approach.

Passive Investing With Global ETFs

Global ETFs enable passive investors to easily gain access to markets outside of the United States without worrying about constructing a portfolio. For example, an investor may decide to hold a low-cost S&P 500 ETF and an ex-US ACWI ETF to provide international exposure. This approach is similar to using index funds rather than picking individual stocks, which as mentioned above, tends to be a better choice to maximize long-term returns.

The benefit of this approach is that it’s easy to setup and maintain and often performs better than actively managing a portfolio. In general, passive investors should seek out international funds that have the lowest expense ratio while still meeting their investment objectives. A great example of a cheap All-World ex-US ETF is the Vanguard FTSE All-World ex-US ETF (NYSE: VEU), which has an expense ratio of just 0.15%, as of October 2016.

The most significant drawback of this approach is that investors can’t fine-tune their exposure to specific markets. For example, Japanese stocks may be overvalued in the eyes of investors, but there would be no way to avoid investing a significant portion of assets in the country.

These dynamics may limit investors from reducing risk in their portfolios, while potentially missing out on opportunities to generate outsized returns.

Finding a Middle Ground

There are some instances where investors can find a middle ground and use both country and international ETFs to their benefit. For example, an investor may hold a passive international fund and then supplement it with smaller positions in country ETFs as needed when opportunities arise. A long position in a country ETF could expose the investor to potential gains, while a short position could limit potential risks.

These actions make sense in a number of different cases — even for passive investors. The ‘Brexit’ referendum was a great example of a large political risk on a set date affecting a specific region of the world.

Passive investors may have hedged their international ETFs by buying put options on Britain ETFs to recoup potential losses if the decision went the wrong direction. These investors may have missed out on gains, but limiting risk is more important at times.

The Bottom Line

International investors have a number of different choices when it comes to investing in global markets, including both country ETFs and international ETFs. Active investors might prefer country ETFs due to their flexibility, while passive investors may prefer international ETFs as a simpler option that tends to do better from a return standpoint. Investors should carefully consider the pros and cons before making a decision either way.