Top ETF picks for international equity exposure

A dose of foreign stocks can help diversify Canadian portfolios.

John Gabriel 12 March, 2015 | 5:00PM
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Note: This article is part of Morningstar's March 2015 ETF Investing Week special report.

Foreign developed market stocks can offer reasonable diversification benefits to Canadian investors. Including them within a portfolio may help diversify away risks linked to local markets, interest rates and currencies. For example, the risk of rising interest rates may be smaller in Europe and Japan than in Canada. The asset class also tends to offer greater exposure to defensive sectors such as consumer defensive and healthcare than most broad Canadian index funds, which may help improve diversification.

That said, investors should keep in mind that foreign developed-market large-cap stocks are typically global firms that increasingly generate a majority of their revenue outside of their home country or region. As a result, the performance of the asset class is tied to the health of the global economy. As the global economy has become increasingly integrated, correlations across markets have increased. In the 1990s, the trailing three-year correlation between the monthly returns of the MSCI EAFE Index and the S&P/TSX 60 Index was 0.4. Today, the correlation is more than 0.8. However, that is no reason to abandon global diversification.

Just like with the ETF options for U.S. equity exposure, currency hedging is an important consideration when investing in international stocks. Investors have the choice between unhedged and Canadian dollar-hedged exposure to the asset class. For example, BMO MSCI EAFE Hedged to CAD ZDM and BMO MSCI EAFE ZEA both offer exposure to the same index, but ZDM is hedged, while ZEA is unhedged.

For the sake of simplicity and diversification, I tend to favour the unhedged options. Investors with very long horizons shouldn't get consumed in trying to predict currency markets. In the end, foreign currency exposure can provide added diversification. Moreover, currency hedging is often imperfect and can lead to increased costs and tracking error. Investors should review their own particular situation and decide what best matches with their objectives and risk tolerance.  Click here for more on currency hedging.

Exploring the options

A simple screen of ETFs in the International Equity category with more than $100 million in assets offers up a strong list of candidates to select from. To help investors wade through the options, I've also included commentary on the various investment options.

International Equity ETFs
Name Ticker Assets
($Mil)
MER Inception
Date
iShares MSCI EAFE CAD-Hedged XIN 1,201.2 0.50 Sept. 2011
BMO MSCI EAFE Hedged to CAD ZDM 799.1 0.34 Oct. 2009
BMO MSCI EAFE ZEA 364.2 0.28 Feb. 2014
iShares Core MSCI EAFE IMI XEF 292.1 0.24 April 2013
Vanguard FTSE Dev ex North Amer ETF CAD-H VEF 286.6 0.29 Nov. 2011
iShares International Fundamental CIE 270.0 0.73 Feb. 2007
RBC Quant EAFE Dividend Leaders (CAD) RID 189.9 0.56 Jan. 2014
Vanguard FTSE Dev ex North America VDU 182.8 0.30 Aug. 2013
Data as of Feb. 28, 2015
Source: Morningstar

iShares MSCI EAFE Index ETF (CAD-Hedged) XIN
This fund offers diversified currency-hedged exposure to about 900 large- and mid-cap stocks in developed Europe, Asia and Australia. It does this by buying the U.S.-listed iShares MSCI EAFE EFA exchange-traded fund, then using forward contracts to hedge its exposure to the 13 currencies in which its holdings are denominated. European stocks currently represent about two-thirds of the portfolio, while Australian and Japanese make up most of the balance.

The fund tracks the MSCI EAFE 100% Hedged to CAD Index, which weights its holdings by float-adjusted market-capitalization and represents roughly 85% of the investable market-capitalization in each of the 21 developed-market countries in the index.

While the fund's currency hedge may hurt returns when the Canadian dollar weakens relative to other currencies, it can boost returns when the Canadian dollar strengthens. However, the addition of currency hedging increases costs. Over the past decade, the fund has actually exhibited greater volatility than the unhedged MSCI EAFE CAD Index. This is because the Canadian dollar has been more volatile than the local currencies that the fund hedges.

While XIN is the oldest and largest ETF on the list and offers tremendous liquidity, several newer options have become available offering similar or identical exposure at a lower cost.

BMO MSCI EAFE Hedged to CAD ETF ZDM
One example of this is ZDM, which tracks the same bogy as XIN, but for a lower fee. BMO recently slashed its management fee to 0.20% from 0.40%, giving it an instant advantage over the higher-priced XIN. When evaluating ZDM's performance since inception, note that it had originally tracked the Dow Jones Developed Markets ex-North America Index.

BMO MSCI EAFE ZEA
This fund is a strong choice for unhedged, low-cost exposure to the MSCI EAFE Index. Those who believe that the Canadian dollar will weaken relative to the other foreign currencies during their expected investment horizon are likely to favour an unhedged option like ZEA.

iShares Core MSCI EAFE IMI XEF
This ETF provides the same country exposure as its sibling XIN but includes the full market-cap spectrum. This means it reaches down into mid- and small-cap stocks, offering more comprehensive exposure to the investible market. The benchmark that XEF tracks contains more than 3,000 stocks, compared to about 900 for XIN's benchmark. XEF does not hedge its currency risk. A currency-hedged version is now available (launched Feb. 10, 2015) under the ticker XFH, but has yet to garner meaningful assets and trading volumes.

Vanguard FTSE Developed ex North America Index (CAD-hedged) VEF
This fund provides exposure that is very similar to XIN. The major differences are the lower management fee and its inclusion of small-cap stocks. The fund's FTSE benchmark contains about 1,400 stocks. VEF also differs in that it includes stocks from Greece and South Korea--countries MSCI classifies as emerging. The non-currency-hedged version of VEF is Vanguard FTSE Developed ex North America Index VDU.

iShares International Fundamental Index CIE
CIE offers diversified international stock exposure by tracking the FTSE RAFI Developed ex-U.S. 1000 Index. Its benchmark targets stocks in developed Europe, Asia, Canada and Australia and weights its holdings using fundamental measures of size, such as cash dividends, free cash flow, total sales and book value. This may be a suitable core holding for investors interested in getting exposure to value stocks in developed markets.

Fundamental indexes' rebalancing approach also introduces a value tilt relative to a market-cap-weighted index. The idea is that as stocks become more expensive, their market capitalizations tend to increase, giving them greater weight in a market-cap-weighted index. In contrast, cheaper stocks tend to receive smaller weightings. On the other hand, the fund's index rebalances back to its holding's fundamental measures of size. This causes it to sell stocks that have outperformed and trade at premium valuations and to reinvest the capital in stocks that have underperformed and trade at discounted valuations.

RBC Quant EAFE Dividend Leaders (CAD) RID
Like CIE, this ETF also employs a proprietary screening and weighting methodology in an attempt to provide improved risk-adjusted returns relative to traditional market cap-weighted benchmarks. Whereas CIE contains more than 1,000 stocks, RID is much more concentrated with 140 holdings. Though it is pricier than its purely passive peers, RID is a bit cheaper than CIE. The fund also makes monthly distributions, while CIE pays out quarterly. RID is unhedged and trades in Canadian dollars. There is also a currency-hedged version that trades under the symbol RHI and an unhedged version that trades in U.S. dollars under the ticker RID.U.

My picks

My pick for investors seeking non-currency-hedged exposure to developed international stocks is XEF, which provides comprehensive coverage at a very low cost. Those who wish to hedge their foreign currency exposure may favour VEF instead.

Note that the list above focuses only on ETFs in the International Equity category, which typically exclude North-American stocks. Thus, investors need to maintain a separate allocation for U.S. and domestic equity. Those who prefer a one-stop solution for exposure to the global stock market can look to iShares MSCI World Index XWD. Another option is iShares Core MSCI All Country World ex-Canada Index XAW, which was launched on Feb. 10, 2015 with a very low management fee of 0.20%. Since Canada is not included, XAW can be used alongside the domestic equity ETF of your choice (with no overlap) to complete the equity portion of your portfolio. XAW is also unique in that it has a 10% stake in emerging market stocks.

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John Gabriel

John Gabriel  John Gabriel is a strategist for Morningstar’s manager research team.

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