Exchange-traded funds that track international markets started the year with tremendous promise but ultimately lost ground to a host of fundamental concerns.
Despite the best efforts of the European Central Bank to stimulate economic growth through quantitative easing programs, both developed and emerging markets overseas saw momentum vanish in 2015.
The hazards in China and Brazil have been well documented and weighed as a primary concern for growth in emerging market countries. In Europe, the fiscally conservative German stock market was rocked by the Volkswagen scandal alongside other financial worries.
The combination of these issues alongside the volatility in U.S. stocks has led to widespread selling in broad-based indexes over the last five months.
Is The Worst Over for International ETFs?
The iShares MSCI EAFE ETF (EFA) is the largest international ETF, with over $56 billion in total assets. EFA tracks about 900 stocks in both developed and emerging foreign markets. In its market-cap-weighted form, the top country allocations are Japan, United Kingdom and France.
Since hitting a high in May, EFA has fallen more over 18% to the September low — just barely avoiding a drop into bear-market territory. This route was initially started by weakness in emerging markets, but has seen Europe join in to drive prices lower in recent months.
Like nearly all risk assets, the October rally has led to some relief of the selling pressure in EFA and barely pushed the index back into the black for the year.
Another key item of note in international markets is the price action of the U.S. dollar, which sent a lot of money spinning into currency-hedged ETFs at the beginning of the year. The PowerShares U.S. Dollar Bullish Fund (UUP) has been decidedly flat over the last five months. Recent price action may even suggest a mild downside bias, which could lead to a test of support at $24.50 in the near future.
ETFs such as the WisdomTree Europe Hedged Equity Fund (HEDJ) benefited from the rise of the dollar as the built-in currency arbitrage worked as a tailwind in the first half of the year. Now there is less of a convincing case that the U.S. dollar will continue its rally and lend weight to the currency-hedged theme.
A falling dollar would ultimately make a traditional international fund such as the Vanguard Europe ETF (VGK) a more attractive near-term opportunity.
Of course, this is predicated on the expectation that the October rally in global stocks has further room to run through the end of the year.
I would sum up the state of international markets with the following bullet points:
- From a pure price perspective, broad-based international ETFs were leaders on the upside and consequently leaders on the downside relative to U.S. markets this year. That makes them a more aggressive play for those who are positioned for a rebound.
- While it appears that there are sound fundamental and technical reasons to avoid international stocks, they still offer compelling upside opportunity in the context of a well-diversified portfolio. Your allocation to this sector will likely be governed by your overarching risk tolerance.
- For core international exposure, I believe that it’s important to stick with broad-based indexes rather than trying to hand-pick specific countries or sub-regions. The risk of hits and misses in concentrated areas make for a less compelling investment proposition.
- International investors should keep one eye on the currency trends as well. Even if your fortunes aren’t tied to a currency-hedged ETF, there are still important correlations that can be gleaned from observing forex markets. Remember that a higher dollar (lower euro) favors currency-hedged positions, while a lower dollar favors traditional un-hedged exposure.
Growth-oriented investors can still benefit from a strong comeback in international stocks given the backdrop of global stabilization. However, it is imperative to have a counterintuitive mindset that allows you to identify opportunity on the way down and curb your enthusiasm in the late stages of a rally.
Be mindful of the inherent volatility in international ETFs versus the major U.S. indexes as well.
David Fabian is Managing Partner and Chief Operations Officer of FMD Capital Management. Learn More: Why I love ETFs, And You Should Too. At the time this article was published, some clients of FMD Capital Management owned shares of VGK.