By Jim Wiandt, Managing Editor

"Diversify your portfolio globally. It will provide your financial profile with not only increased stability, but very possibly higher yields with less risk." - Jim Wiandt

You've got a house, a broad section of the U.S. Market, and some bonds. You think you're diversified? Think again. Without a healthy allotment of international stocks, your porfolio is not as diversified as it should be.

An array of financial advisors in the index fund community advocate minimal exposure abroad, claiming that U.S. multinationals provide adequate diversification abroad. Still others say that historically, United States and foreign markets have very high levels of correlation, particularly during bear markets, when you need the benefits of diversification most. I will go through these issues (and many more) point by point, bringing each to its knees.

The Current State of Affairs

Most Americans are shamefully underinvested abroad. According to the Investment Company Institute, at the end of 1999 there was a total of $6.85 trillion invested in U.S.-based mutual funds. Of that total, only $585 billion was invested in international funds. This amounts to 8.5% of the mutual fund total. And this, despite the fact that according to Morgan Stanley Capital, foreign stocks account for some 51% of global capitalization.

Source: Morgan Stanley Capital International (MSCI)

Furthermore, the problem seems to be getting worse, not better. The most recent statistics also indicate that new cash flow has been going disproportionately into U.S. funds. This is owing largely, of course, to the declaredly higher returns of the U.S. market...more money chasing higher returns. In 1998 and 1999, only 5-6% of new mutual fund money was going into international funds.

OK, you say, so Americans don't invest abroad. I don't need to look any further than my own portfolio to know that. Give me one good reason to put my money in risky global markets. I'll give you several.

1) Foreign markets do not move in lockstep with U.S. markets. Oftentimes, when United States markets fall, international markets rise and vice versa. A simple examination of returns over the past 10 years shows that while international and U.S. markets do sometimes move in tandem, their performances often move counter to each other. The net effect, of course, with ANY divergence of returns is increased portfolio diversification.

As a sidenote, I would add that many global indexes (such as the EAFE, an index containing representation across the developed markets of Europe and Asia) are weighted heavily toward large cap stocks. Often these stocks, like U.S. multinationals, are more likely to move in step with the United States/global economy. While there are diversification benefits in buying large foreign equities, the cross-correlation/ diversification benefits rise exponentially with small foreign stocks that are more tied to local economies.

Walter Updegrave of Money Magazine examined recent correlation levels of U.S. and international stocks. (If two assets are perfectly correlated, they have a correlation of 1.0, if they are in synch but in opposite directions, correlation is -1.0. If their returns are unrelated, the correlation is 0.) Updegrave found that over the past five years, most large cap-biased foreign funds had a correlation with the S&P 500 of .70 or higher (compared to 0.59 for the U.S. small cap Russell 2000). However, correlations of foreign small cap funds were lowest of all, with the Dreyfus Founders Passport fund coming in at 0.23%.

2) Your portfolio should act as a diversifier to your complete financial profile. You have a job at the front edge of the New Economy. You've bought a penthouse apartment in Manhattan. Your salary and the value of your assets are dependent on the state of the U.S. economy. In the same way you should buy bonds to hedge against a catastrophic collapse of the U.S. economy and subsequent loss of your job, decline in property value, etc., you should also diversify internationally as a hedge against your huge bet with the U.S. economy.

3) U.S. multinationals do not provide adequate exposure to foreign markets. For a number of reasons, U.S. multinationals, despite deriving a significant percentage of their revenues abroad, do not provide adequate foreign exposure. Most of their costs (particularly labor) are from the U.S., as is the majority of the capital they raise. In addition, most of these companies are primarily held by U.S. investors in U.S. markets, and tend to act in concert with the domestic market (and therefore the domestic U.S. economy).

4) International markets can provide some cover for U.S. investors during a downturn in the U.S. economy. I list 1977, 1984, and 1987 as examples of years when the U.S. market was bearish, while foreign markets were bullish, providing ballast for diversified U.S. investors. Even if U.S. and foreign markets moved largely in step, with a correlation of, say 0.75, this still provides diversification benefit.

5) Foreign markets are becoming more hospitable to investors. In Europe and Asia, in particular, financial and tax systems are becoming increasingly standardized and transparent. In addition, the vast new influx of European pension investors bodes well for the European equities markets. While (tsk tsk) it is a timing argument, European markets are on the front end of the pension boom that has largely run its course in the United States.

5) Japan 1989. This is all I need to know to be certain that I should be fully diversified internationally. There is always the possibility that the U.S. economy will fall into a brutal, prolonged bear market that is not shared by the rest of the global stock market. Call it reversion to the mean. Japan's economy was declared infallible in the 1980s, and its stock market rose to stratospheric levels not unlike those the U.S. economy is enjoying today. When the party was over, though, it was really over. While the Wilshire 5000 index of the total U.S. market has enjoyed annualized returns of 17.27% over the past 10 years, and a blistering 22.45% over the past five, the Japanese market has run up an abysmal 0.07% over the past 10 years, and lost 1.35% annulized in the last 5.

6) (and this is the clincher) The evidence seems to indicate that internationally diversified porfolios just flat outperform porfolios containing only U.S. equities. Furthermore, these higher returns have come without extra risk (measured for our purposes by standard deviation).

To illustrate my point, I have dipped into the resources of team DFA (Dimensional Fund Advisors), using data and charts provided by Mark Hebner of Index Funds Advisors. The first chart allows you to see the composition of the DFA model porfolios to understand what is being compared.

The second chart is the most instructive. It shows a comparison of returns of different DFA portfolios compared with the booming S&P 500 index, on which about 100 mutual funds are based, and which has in recent years enjoyed returns considerably higher than those of the total U.S. market.

This, of course, amounts to considerably more capital gain, and with slightly less risk (standard deviation) than was found in the S&P 500 over the same time period.

Conclusion

The conclusion could not be more simple. Diversify your portfolio globally. It will provide your financial profile with not only increased stability, but very possibly higher yields with less risk.

Appendix B:
"U.S. Multinationals Aren't So Foreign"
By Rahul Seksaria, Assistant Editor

Review of article from The Wall Street Journal, June 22 1999 (fee-based interactive edition)

Mr. Clements reasons that investing in U.S. multinationals does not provide international diversification to an investor's portfolio. Investors putting their money into U.S. funds laden with multinationals, with the intention of diversifying their domestic portfolio, might be better off investing in international index funds to get broad foreign market exposure.

"An increasingly popular strategy is to eschew foreign stocks and instead get overseas exposure through U.S. multinationals such as Boeing, Gillette, Johnson & Johnson and Motorola. It is far more comforting to own these U.S. multinationals than to go dabbling in foreign stocks, with all their currency swings and the occasional political turmoil," writes Clements.

But is this a prudent strategy? Clements claims that U.S. multinationals, many of which get over half their revenues from overseas sales might seem to be a good proposition for international diversification but they don't behave like foreign stocks in actuality. In recent years, while international stocks have not performed well, U.S. multinationals have posted big gains just like the rest of the U.S. stock market. "They tend to trade in sync with the U.S. market and thus owning them doesn't do much to reduce a U.S. stock portfolio's risk level."

Thus, investors seeking to smooth out their portfolio returns through international diversification must invest in foreign stocks as their pattern of returns differs greatly from that of U.S. multinationals. Investments in foreign shares can salvage a bad year for the U.S. stock market investor just as it did in 1977, 1987 and 1994.

International index funds are an efficient way to invest in foreign stocks. Their relatively low cost and tax efficiency enhances net portfolio returns, which are on average higher than the returns of actively-managed funds. WEBS offer another way to get broad market exposure in specific countries.

Nobody knows for sure why U.S. multinational stocks have behaved in this manner but a number of potential reasons have been given:

The bulk of their costs are in the U.S. and they also raise capital in the U.S.
They don't differ much from domestic firms, all of which face intense competition from foreign firms.
They are owned primarily by U.S. investors and tend to behave like U.S. stocks.

Review of Jonathan Clements article in The Wall Street Journal, June 22 1999

Appendix C:
Exchange-Traded Indexed Securities
By Michael O'Neil Meditz, Associate Editor

Exchange-traded funds (ETFs) are increasing in popularity, as they are often responsible for approximately 50% of the daily trade volume on the American Stock Exchange (AMEX). ETFs are passive funds that track their related index and have the flexibility of trading like a security. They are managed by professionals and provide the investor with diversification, cost and tax efficiency, liquidity, marginability, are useful for hedging, have the ability to go long and short, and some even provide quarterly dividends.

ETFs are unit investment trusts (UITs) that have two markets. The primary market is where institutions swap "creation units" in block-multiples of 50,000 shares for in-kind securities and cash in the form of dividends. The secondary market is where individual investors can trade as little as a single share during trading hours on the exchange. This is different from open-end mutual funds that are traded after hours once the net asset value (NAV) is calculated.

The most widely traded and well-known ETF is the SPDR (pronounced spider, Standard and Poor's Depository Receipt). Other ETFs include Diamonds (Dow Jones Industrial Average), Qubes (Nasdaq-100 Index Tracking Stock) named after the ticker, QQQ, and Webs (World Equity Benchmark Shares). Webs mirror indices in foreign equity markets. There are currently 30 ETFs available on the AMEX and they include 17 Webs, 11 SPDRs (includes sectors), and one Qube and one Diamond.

Tax Advantages

Like open-end index funds, ETFs do not engage in active management and experience very low portfolio turnover. Also, ETFs provide additional tax benefits that mutual funds cannot offer. Mutual funds sell securities to cover redemptions that produce capital gains. ETFs transfer out, not sell, securities "in-kind" in the primary market. The institution can determine which, and how much of a security they are going to swap as long as it is of equal value to the amount being redeemed. The benefit of swapping securities at the lowest cost-basis is that it avoids capital gains. However, individual investors trading in the secondary market could be subject to capital gains since they do not have the opportunity to swap securities in kind.

Costs

Most open-end index funds can be purchased directly from their distributors without a transaction fee. Those bought through the discount brokers like Charles Schwab or E*Trade usually include a transaction charge of $15-$30 or more. Exchange-traded funds, on the other hand, are subject to regular brokerage commissions on all purchases and sales. An additional cost to investors in ETFs is the "spread" between the bid and ask price. This can amount to over 1% of the purchase or sale price.

Expense ratios (ER) are very similar among ETFs and open-end index funds. However, there is often an additional cost of ownership to holding ETFs. SPDRs, for example, pay dividends quarterly directly to investors. An open-end index fund like the Vanguard 500 Index reinvests dividends into new shares as they are paid. The delay of dividend reinvestment with ETFs is often referred to as "dividend drag."

New and Improved ETF

Barclays Global Investors (BGI) currently manages all 17 of the WEBs available on the AMEX and has filed with the SEC with plans to offer 51 new ETFs including 45 domestic and 6 international sector and wide-market indices. BGI is planning a competitive pricing strategy and the internal expense ratio estimates range between 8 and 12 basis points. Their goal is to design tax efficient and less expensive funds to grab market share. A key difference between the Barclays securities and the currently available ETFs is that they will be registered with the SEC as open-end funds. BGI is still keeping the benefits of exchange-traded securities while overcoming the problem of dividend drag.

Exchanged-trade index funds offer investors even greater flexibility than open-end index funds and may offer cost and tax advantages. Investors should be aware, however, that the unique advantages of ETFs, such as greater trading flexibility and the ability to sell short, might turn out to be very costly features in the long run. Investors are still wise to avoid the temptation of market timing and use ETFs as part of a diversified, long-term investment strategy.

Appendix D:
Are the Risks of Exchange-Traded Funds Being Downplayed?
By Jim Wiandt, Managing Editor

A key risk inherent in exchange-traded funds (ETFs) is being misrepresented by its proponents, charges Mercer Bullard and the Consumer Federation of America. Sponsors of ETFs responded variously-challenging the critics' data, agreeing, or vowing to change future practices.

At issue is clarifying the nature of ETFs to investors. While most ordinary mutual funds can only be bought or sold at the end of the day at the calculated net asset value (NAV), ETFs are traded through the day on the American Stock Exchange at prices that aren't guaranteed to match the underlying value of the stocks in the portfolio.

With many ETFs the variations are negligible. But some of the funds trade at prices that can vary considerably from the correspondent NAV at the time of the trade. In such cases an investor who inadvertently buys an ETF at a premium to its underlying value is exposed to natural corrective forces (namely savvy traders who exploit the difference between the trading price and the NAV).

According to Mr. Bullard, the risk of price variation is greatest on international stocks. Materials from ETF proponents and the American Stock Exchange have "misrepresented" the risk, he contends.

In a Wall Street Journal article by Karen Damato and Aaron Lucchetti, various ETF supporters responded to the charges. Lee Kranefuss of Barclays Global Investors, said his firm had fully disclosed the mechanics and risks of ETFs. Even so, in May Barclays agreed to provide additional information on its ETF Web site about the daily premiums and discounts of some of its iShares.

Presently many of the ETFs that trade on the American Stock Exchange have three ticker symbols: one shows the trading value, another shows the estimated NAV of the underlying stocks, and the third shows the official NAV of the underlying stocks at the previous day's close.

Unfortunately, this information is presently only available for United States-based ETFs. The same information is not readily available to most retail investors trading in low-volume international funds. With the recent exposure to this information, however, look for this information to soon appear.

Gus Fleites, director of ETFs at State Street Global Advisors, agreed that price variation can be significant for some funds and may not always be explained clearly. Regarding ETFs that track international-stock indexes or lightly traded U.S. industry sectors, he noted, "Retail investors, beware…."

Fund specialists, including Mr. Bullard, have praised ETFs not just for allowing intra-day trading, but also for their ability to feature lower operating expenses and greater tax efficiency. Expect the transparency of trading/NAV differentials to increasingly fall into the public domain. Traders, not funds, gain from the premiums/ discounts.

With Barclays already voluntarily posting the information, it seems likely the problem will soon to be largely resolved. Aside from increased transparency cutting down the gap, one expects that the increased attention to the issue will also help narrow the premiums that are exploited by traders. In the meantime, let the buyer beware.

Hidden Trading Costs ETF Investors Should Know About
By Will McClatchy, Editor

How does a small investor know he is getting the best price when he buys or sells an exchange-traded fund (ETF)? The truth is that brokers may quite legally complete a trade at less-than-optimal prices and pocket the difference, and the investor may never be the wiser.

How does that happen?

Brokers often buy equity positions to trade, becoming market makers or dealers. In essence this puts them in competition with their own customers. Essentially, the brokers hold inside knowledge of trades in the hopper, and this can lead to handsome profits. Brokers can also route trades to third-parties who profit from completing transactions and who offer cash rebates called "payment for order flow". There is no assurance in either case that the customer has received the best possible deal.

At the center of these issues is the bid-ask spread, or the difference between the lowest price a seller offers and the highest price a buyer will pay. This difference or spread is what gives incentive to middlemen to complete the trade for everyone's benefit. In the era of computer networking, no one believes this spread has to be large for very liquid stocks. At the same time no one believes it will go away completely. A problem common to all stock transactions, the ask/bid issue is a separate one from the trading/net asset value premium discount issue we discussed in a recent article.

The bid-ask spread often costs 1% or more to the investor, acting much like a "load" in a mutual fund and dragging down long-term profits. It is one of the primary drains on the small investor's final returns. The good news is that the ease with which middlemen can abuse their positions is dropping for a variety of reasons, including greater competition among brokers, better technology, and stricter regulatory controls. A bit of vigilance on the part of the investor is the main ingredient to getting a fair trade.

One strategy to avoid being taken advantage of is to issue limit orders, or orders to buy or sell at a fixed price as opposed to market orders which are placed at the "best price". This removes flexibility from the broker - flexibility that can be abused.

There is a misconception that indexers need only worry about bid-ask spreads with exchange-traded funds bought or sold mid-day through a brokerage. Not true. Mutual funds also face bid-ask spread costs because they also trade securities. In addition, funds are exposed to the danger of injecting volatility with big orders that may swing the market. Partial remedies exist for funds to help mitigate both of these trading costs. For instance, Instinet, Reuters' institutional trading system boasts that it ensures anonymity, never holds positions in competition against its customers, and more rigorously seeks the best possible price.

Downward pressure on bid-ask spreads is expected as stock markets "decimalize" stock quotes, which in effect allows spreads to shrink to one penny. The NASDAQ, once criticized for keeping ask/bid increments unnecessarily large, is expected to decimalize major stocks this fall. Currently stocks are listed in 1/16ths of a dollar, while decimilazation will allow them to be quoted in pennies.

Pressure on the bid-ask spread is also coming from numerous electronic exchanges and discount brokers that market their ability to more methodically seek out the best possible price for investors. The ones who don't are being singled out in the media and by word-of-mouth.

Lastly, the Securities Exchange Commission continues to apply pressure on exchanges to decrease spreads.

Perhaps the most controversial aspect of the bid-ask spread is so-called payment for order flow. This occurs when a broker directs large amounts of orders to an independent market maker, a firm whose specialty is bringing buyers and sellers together, taking the spread as profit. Such market makers return stock brokers a cash rebate called payment for order flow. Critics decry it as a crude kickback.

"We have come out fairly strongly against that practice in the past. A broker-dealer who accepts payment for order flow is advantaging one set of customers over another, " says Deborah Mittelman, a Vice President in execution services at Instinet Corp., "They also have a free look at orders before they go to the market."

The SEC barely tolerates payments for order flow, as can be seen from an announcement on the subject his month:

"Since its growth in the 1980s in the equities markets, the Commission has made clear its concern about the practice of payment for order flow. It has repeatedly recognized that the practice constitutes a potential conflict for brokers handling customer orders, and that it may present a threat to aggressive quote competition.

At the same time, we have acknowledged that payment for order flow is not necessarily inconsistent with a broker's duty of best execution, and that it has become a feature of competition among our equity market centers. The Commission decided not to ban payment for order flow in the early 1990s. In considering the arrangements, the Commission noted that payment for order flow is, in substance, the economic equivalent of internalization."

Indeed, research by the Federal Reserve suggests that payment for order flow may actually lower bid-ask spreads. A working paper by by two Atlanta researchers on the subject can be downloaded from the Web.

Kenneth D. Pasternak, CEO of Knight Trading Group, a major independent market maker which pays for order flow, defended the practice before the subcommitte on Securities of the U.S. Senate Committee on Banking, Housing and Urban Affairs, April 26, 2000:

"It has been the subject of incessant debate because it obviously poses a potential conflict: if a market center like ours gives brokers cash rebates or other inducements, how can the investor be sure than an order will receive the best possible execution?"

"…Last year, we rebated nearly $139 million to our broker-dealer clients who sent us their order flow. What our client firms did with that money is a question best answered by them, but no doubt they would tell you that, because of those rebates, their customers paid lower commissions, received more free real-time market data, and more free technical and fundamental analysis of more and more securities."

Payment for order flow may seem like a conflict of interest, he admits, but "the securities industry is rife with conflicts". For instance, firms underwrite and recommend securities at the same time. He advocates full and fair disclosure as the main solution to all such potential conflicts of interest.

Appendix E:
Parade of iShares Continues:
Cheap to Hold, Easy to Trade
By Jim Wiandt, Managing Editor

Barclays Global Investors continues its rollout of iShares. By mid-July, there will be over 50 domestic and international iShare funds available covering just about every broad U.S. market sector, and most of the major international markets.

"Nearly four billion has been invested in iShares thus far, in part because iShares offer a compelling approach to asset allocation strategies. iShares combine low costs, broad diversification, tax efficiency and the flexibility of common stocks, with performance relevant to the index selected. With the launch of the additional products, iShares now offer a complete and modular set of sector funds," said Lee Kranefuss, CEO of BGI's Individual Investor business.

Beginning trading June 16 were 12 new funds, including a wide array of Dow Jones sector funds, as well as a Dow Jones U.S. Total Market fund. A Standard & Poor's/ TSE 60 Canada fund will also be unveiled. For Europhiles, on July 14, the S&P Europe 350 fund hits the market, while an MSCI EMU comes to the market on July 28.

As an added bonus, Barclay's reduced the expense ratios on many of their international MSCI funds effective May 13, 2000. Most MSCI iShares now have expense ratios of 0.84%, down from as high as 1.59%.

The parade of exchange-traded funds continues through July 28th, when Barclays launches iShares funds covering S&P 500/ BARRA Small and MidCap Growth and Value funds, as well as Russell 2000 and 3000 Growth and Value funds.

New MSCI iShare funds for Taiwan and Brazil have already been launched, despite the realignment of Brazil's index as well as regulatory snafus. The South African market was not so lucky, as the planned launch of the South Africa MSCI iShares has been put off indefinitely owing to the potential realignment of its index.

Complete List of all currently available exchange-traded funds: