(08/08/11) 6 Smart International Income ETFs

More than half of the real return provided by US stocks in the past century came from dividends…and in the international developed markets, more companies pay dividends with yields higher than US firms, observes Patricia Oey of Morningstar’s ETF Specialist.

Foreign large-blend and dividend ETFs each have yield premiums of about 100 basis points relative to their US counterparts. In addition, because dividends are more common across foreign equities, foreign dividend funds tend to be better diversified across sectors.

However, while dividends tend to suggest safety, we highlight that there are some risks that are specific to international dividend funds that do not exist for domestic dividend funds.

In the past 15 years, a dividend-focused strategy produced better risk-adjusted returns than a market cap-weighted strategy in the World, EAFE, Europe, and Pacific equity categories. In the United States, dividend-oriented strategies are not more volatile market-cap-weighted strategies.

Outside the US, however, the risk-parity paradigm does not exist. Dividend-oriented strategies internationally are generally more volatile than their market cap-weighted counterparts, and that differential has widened in the past few years.

One reason for this is the fact that foreign companies are not as reluctant to cut dividends when compared with US companies.

Another issue to consider is that currency fluctuations have a greater impact on volatility in the short term than in the long term—exchange rates in the long term tend to be mean-reverting. As such, the gap in the three-year standard deviation between the S&P 500 and the international indexes was wide relative to the gap in the 15-year standard deviation.

Currency volatility in the past three years was also further amplified by the financial crisis. Those who invest in foreign dividend funds for a steady income stream would not have gotten it in the past few years.

Mind the Tax Complications
Investors in international dividend funds also face additional tax issues, including withholding taxes on dividend income. On average, investors in broad international funds and international dividend funds experienced annual withholding rates of around 9% in the past few years.

The US government, in order to prevent double taxation, allows investors to claim this withholding amount as a tax credit. But claiming a tax credit only works for funds held in taxable accounts. Because Uncle Sam does not take his cut from funds held in tax-deferred accounts, investors cannot claim a credit on funds held in 401(k)s or IRAs.

Investors can find out which of their dividends are qualified by checking the tax documents issued by the fund providers at the end of the year.

International Dividend ETFs to Buy
At this time, there are a handful of international dividend ETFs that have three-year track records and reasonable bid-ask spreads (there are currently no ETFs that track MSCI’s international high-yield indexes, which anchor country weightings within a regional index).

Those looking for a lower-volatility international dividend ETF can consider PowerShares International Dividend Achievers (PID), which weights its holdings by dividend yield, while only holding companies that have increased their annual dividends for five or more consecutive years.

Other dividend-yield-weighted ETFs, such as SPDR S&P International Dividend (DWX) and iShares Dow Jones International Select Dividend (IDV), employ less-stringent selection criteria, which results in riskier portfolios.

WisdomTree International LargeCap Dividend (DOL) is an attractive alternative because it weighs its components based on dividends paid as opposed to dividend yield, which has resulted in a less-volatile portfolio of larger and stabler firms.

Those concerned about the tax issues can consider iShares MSCI Australia Index (EWA) and iShares MSCI United Kingdom Index (EWU).

The obvious downside to these choices is the lack of geographic diversification. But both funds are highly liquid, hold many high-quality multinational companies, pay out qualified dividends, and are subject to very low or no foreign-withholding taxes.

The Australia fund, with an attractive dividend yield of 4.1%, has a 42% weighting in financial companies—mainly Australia’s healthy big four banks—and a 29% weighting in materials companies, which are leveraged to emerging-markets growth. The long-term volatility of Australian stocks (in local currency) is even lower than that of the S&P 500, but EWA has greater volatility due to currency effects.

The UK fund holds familiar, high-quality names such as Vodafone (VOD), GlaxoSmithKline (GSK), and AstraZeneca (AZN)—companies with good exposure to global growth. And while shareholders of EWU were subject to a 2% withholding tax in 2010, this was a one-off, as the UK does not have withholding taxes.

So those who want to avoid foreign-withholding taxes can consider EWU for foreign large-blend exposure. However, like most foreign large-blend funds, it has high exposure—20%—to financials, which could be negatively impacted by the ongoing European sovereign debt crisis.

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