Adding international investments to your portfolio is a good way to diversify for safety while boosting returns.
On average, international stocks appreciate more than U.S. stocks. What's more, companies located in countries with the most economic freedom typically appreciate more than the broader international average. Over the past year, countries with the most economic freedom appreciated 7 percent more than the international index.
The MSCI EAFE Index of international developed markets gained 27.0 percent (in U.S. dollars) during the one-year period ending June 30, 2007 and has averaged 22.2 percent annually for the past three years. Compare that to the stock indexes of the 12 most economically free countries which gained 34.0 percent during the past year and returned 25.4 percent annually for the past three years.
For small accounts, investing in a good international mutual fund is usually sufficient foreign diversification for your investments. However, greater diversification and returns can be gained by putting some money into the "emerging markets" category.
Emerging markets, as measured by the MSCI Emerging Markets Index, appreciated 36.6 percent (in U.S. dollars) over the past year and has averaged 26.5 percent over the past three years. Although emerging markets have a higher appreciation rate, they are also inherently more volatile than the markets of more developed nations.
To balance investment performance and volatility, a simple foreign asset allocation might invest two-thirds in the MSCI EAFE Index and one-third in the MSCI Emerging Markets Index. Using this technique, you would have gained 30.2 percent for the past year and averaged 23.7 percent over the past three years.
For larger accounts, a more complex asset allocation can be used for further diversification. This asset allocation strategy takes advantage of the fact that economic growth is often better in those countries with the greatest economic freedom. We use the Heritage Foundation's measurement of economic freedom to emphasize those countries that combine the greatest economic freedom with large investable markets.
Since its inception in 1994, the Heritage Foundation Index of Economic Freedom has used a systematic, empirical measurement of economic freedom in countries throughout the world. The conclusions from this study clearly demonstrate that countries with economic freedom also have higher rates of long-term economic growth.
This makes the study useful for investors to use to decide which countries should be emphasized in their country-specific foreign stock allocation.
According to the Heritage Foundation's study, "Economic freedom is defined as the absence of government coercion or constraint on the production, distribution, or consumption of goods and services beyond the extent necessary for citizens to protect and maintain liberty itself. In other words, people are free to work, produce, consume, and invest in the ways they feel are most productive."
A country's economic freedom score is based on 50 measurements that fall under the following categories: trade policy, fiscal burden of government, government intervention in the economy, monetary policy, capital flows and foreign investment, banking and finance, wages and prices, property rights, regulation, and informal market activity.
A number of the countries ranked high in economic freedom have exchange-traded funds (ETF's) which track the market indexes of these countries and provide an easy, convenient, and inexpensive way to invest in each country. Exchange-traded funds combine the liquidity of individual stocks with the diversification of an index fund.
The ETF's also typically have lower expense ratios than most mutual funds.
For larger accounts, we recommend investing half of the assets using the simple technique described above. As such, one-third is invested in the MSCI EAFE Index fund and one-sixth in the MSCI Emerging Markets Index fund. The other half is divided among the twelve countries with the most freedom that also have markets large enough to have a country-specific ETF.
All of the top 12 most economically free countries, except Japan, beat the United States's 20.6 percent return over the past year as measured by the S&P 500. In descending order, the past year's investment returns for the top12 countries are as follows: Singapore 60.7 percent, Germany 48.8 percent, Sweden 44.3 percent, Australia 43.6 percent, the Netherlands 38.4 percent, Austria 36.4 percent, Belgium 33.2 percent, Hong Kong 29.5 percent, Canada 28.3 percent, the United Kingdom 27.4 percent, Switzerland 22.5 percent, and Japan 7.23 percent.
Over the past year, 10 of these countries beat the broad MSCI EAFE Index, and only two Switzerland and Japan) fell short. Of the 12 countries, Japan and Belgium were only ranked high enough by the Heritage Foundation's Freedom index this past year to warrant being added as country-specific investments. While Belgium's index had nice returns, Japan has not yet contributed as much.
Averaged together, the top 12 free countries gained 34 percent this past year. This is a full 7 percent above the MSCI EAFE Index which gained 27 percent. Excluding Japan, the other economically free countries beat the MSCI EAFE by a full 11 percent.
Over the past five years, investing in countries with the most economic freedom is a strategy that has beaten the MSCI EAFE Index by an average of four or five percentage points annually.
Diversifying your foreign investments is just one important component of an optimal asset allocation. Building balanced portfolios that are more likely to meet your financial goals doesn't happen by accident or by working with someone whose interests are in conflict with yours. Visit NAPFA at www.napfa.org to find a Fee-Only advisor in your area or call NAPFA at 1-800-366-2732.
Marotta Asset Management, Inc. of Charlottesville provides fee-only financial planning and asset management. Visit www.emarotta.com for more information. Questions to be answered in the column should be sent to firstname.lastname@example.org or Marotta Asset Management, Inc., One Village Green Circle, Suite 100, Charlottesville, VA 22903-4619.
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