(08/14/13) Nine Favorite Foreign ETFs

Foreign ETFs typically offer improved trading flexibility, potentially better tax efficiency, and lower expenses compared to traditional international mutual funds, explains Richard Moroney, editor of Dow Theory Forecasts.

Investors seeking foreign exposure through ETFs should keep in mind the five tips below:

Review company, sector, and country exposures.

Some of the largest and broadest ETFs are fairly concentrated, making them more aggressive than you might think. For example, nearly one-third of SPDR S&P International Dividend (DWX) is invested in just ten stocks. This top-heavy fund holds 22% in financials, and stocks hailing from Australia represent 26% of assets.

Gauge diversification benefits.

Foreign funds can help mitigate the volatility of a mostly US stock portfolio. But many international ETFs, particularly those slanted toward large-company stocks, generate returns more than 95% correlated with the popular MSCI EAFE Index, which contains mostly stocks from developed countries in Europe, Australia, and Asia.

Over the years, the EAFE index has become increasingly correlated with large and mid-cap US stocks. Investors should consider emerging-market or small-cap and mid-cap foreign ETFs, which may offer more diversification benefits.

Make accurate comparisons.

Most fund returns are measured against the EAFE index. But about 17% of the index is invested Japan—the best-performing major market in 2013.

Thus, a mediocre fund might look particularly good this year if it had an outsized weighting in Japan. Investors should compare fund performance to both index and peer-group returns.

Evaluate expenses carefully.

Not all ETFs are bargains, and international funds can be relatively pricey, as many have expense ratios above 0.80%. In addition, because many foreign ETFs are strongly correlated to the EAFE index, and tend to generate similar returns, investors should focus on the lowest-cost funds.

Vanguard FTSE Developed Markets ETF (VEA), a good all-purpose foreign ETF that invests mostly in large-company stocks, charges a tiny 0.10% annual expense ratio, versus a category average of 0.57%.

Be aware of currency risk.

Exchange rates can fluctuate sharply and unexpectedly, impacting ETF performance. Some funds hedge currency exposure to limit the impact of exchange-rate fluctuations. But hedging can be difficult and expensive.

Moreover, a hedged ETF generally offers less diversification benefits. Unless you have a strong opinion that the US dollar is likely to strengthen versus other currencies, an unhedged ETF is a better choice for most investors.

Here are nine standout international ETFs: