Diversify Your Portfolio Outside the US

Asset allocation is the most influential factor on investment outcome.  There have been growing signs that the worst of the global crisis might have passed.  While the US dollar may continue to weaken and the US loses significance in the global landscape, an allocation to other developed markets is deemed necessary.  After all, 76% of global GDP is outside the US.  

The most popular ETF to provide global diversification is iShares MSCI EAFE ETF (EFA), which tracks Europe, Australasia and Far East Index of developed countries.

GDP vs. Market Cap

EFA weights countries based on their market capitalization rather than GDP.  The following chart shows its country breakdown:

As you can see from the GDP chart below, Germany accounts for 6% of world GDP, much higher than UK’s 4.4%.  However, its share in EFA is much smaller than the U.K.’s.

Top 5 Countries Within EFA

Country ETFs are another great way to organize a global portfolio.  The following are top 5 countries and their ETFs within EFA:

Fund ( Symbol)

Assets

P/E

iShares MSCI Australia (EWA)

$2.1B

21.7

iShares MSCI France (EWQ)

$313M

21.9

iShares MSCI Germany (EWG)

$875M

23.1

iShares MSCI Japan (EWJ)

$4.8B

28.7

iShares MSCI UK (EWU)

$888M

24.7

1. Australia is a country that has weathered the global financial crisis better than most others. Since 1990, Australia has had only one quarter of negative GDP (-0.7% in Q4 '08).   An unemployment rate of 5.8% is also the lowest in developed economies. Chinese growth means increased demand for Australia’s natural resources.

The euro-zone jobless rate inched up to 9.7% in September, the highest level since records began in 1999.  Consumers hit by mounting job losses can’t support the economic recovery by spending heavily.  No wonder the EU’s retail sales dropped by 0.7% in September.

The European Commission predicted that the EU will grow in 2010 at a modest rate of 0.7% as the economy moves from a sharp recession to a hesitant and fragile recovery, according to Associated Press. With low wage growth and rising productivity growth, Germany has slowly regained its competitiveness.  In other countries, such as Spain and Italy, exports tend to be low value added and labor intensive.  The divergence of growth rates within the euro-zone is becoming worse. 

The EU’s debt/GDP ratio is set to rise from 78% this year to 88% in 2011, far above US’s.  But they are still much better than Japan’s 170%. 

Currency ETFs

US interest rates near zero and monetary easing have given rise to a carry trade of the U.S. dollar.  The following are EFA economics’ currency ETFs:

Fund ( Symbol)

Assets

CurrencyShares Australian Dollar (FXA)

610M

CurrencyShares British Pound (FXB)

151M

CurrencyShares Euro Trust (FXE)

554M

CurrencyShares Japanese Yen  (FXY)

516M

PS DB G10 Currency Harvest (DBV)

386M

PS DB US Dollar Index Bearish (UDN)

335M

PS DB US Dollar Index Bullish (UUP)

501M

Top 15 Holdings Inside EFA

The following are EFA’s top 15 stocks (by % of assets) traded in the US exchanges:

Name (Symbol)

Sector

% Net Assets

Forward P/E

Mkt Cap

HSBC HOLDINGS PLC (HBC)

Financials

1.99

19.1

197.37B

BP PLC (BP)

Energy

1.66

10.1

182.62B

BANCO SANTANDER (STD)

Financials

1.29

9.0

136.36B

TOTAL SA (TOT)

Energy

1.27

8.9

139.27B

VODAFONE GROUP (VOD)

Telecom

1.18

9.2

118.98B

TELEFONICA SA (TEF)

Telecom

1.18

10.0

130.80B

BHP BILLITON LTD (BHP)

Materials

1.12

16.9

189.11B

TOYOTA MOTOR (TM)

Consumer Disc

1.09

25.1

122.55B

NOVARTIS AG-REG (NVS)

Health Care

1.07

12.6

119.92B

GLAXOSMITHKLINE (GSK)

Health Care

1.03

10.3

105.12B

ROYAL DUTCH SHE (RDS-A)

Energy

1.01

N/A

188.27B

SANOFI-AVENTIS (SNY)

Health Care

0.78

7.5

100.27B

SIEMENS AG-REG (SI)

Industrials

0.77

13.6

79.82B

WESTPAC BANKING (WBK)

Financials

0.66

14.6

70.80B

BARCLAYS PLC (BCS)

Financials

0.66

N/A

62.10B

Based on Yahoo Finance next year’s estimated EPS, the top 15 holdings average forward P/E is 12.8.

EFAs biggest sector is Financial, which accounts for 26.5%.  Australia’s big-4 banks have maintained strong capital bases in recent years.  Problem loans are forecast to decline next year when earnings are set to rebound.  Other banks still face lots of problems.  Santander (STD), the euro-zone's largest bank, boosted provisions for an expected rise in bad debts from the housing boom hangover.

One of promising sector is HealthCare, which might be benefit from H1N1.  In addition, they are entering the fast-expanding Chinese healthcare market in a big way.  Novartis (NVS), the Swiss drug giant, is pumping $1.25 billion to build two R&D centers in China. 

Conclusion

Global markets are functioning normally and they might have more upside potential.   The G-20 may decide to reassure markets that stimulus will remain in place until a sustainable recovery has been assured.  Interest rates in core countries are likely to remain low for a long time. Consumers are becoming less pessimistic about the economic outlook. 

However, record high and rising unemployment as well as financial uncertainty continue to weigh on global consumer confidence.  iShares.com shows that as of Oct 30, EFA’s P/E is 23, which is very expensive.  Its forward P/E is quite attractive though.

I have accumulated EFA over time and now it has become one of my core holdings.  While there is a steady rise in correlation between US and other countries' stock markets, EFA might still give you the chance to benefit from diversification.  Alpha-seeking investors might be able to profit more by handpicking countries, sectors, or even stocks.