Indexing allows advisors to invest in the entire foreign stock universe with a single ETF. Adding a country-specific ETF to the mix increases exposure to that nation, but can also substantially tilt sector weightings. The result can be a major overlap that distorts the portfolio’s sector allocation.
“Single countries can have significant sector concentration,” says Patricia Oey, senior fund analyst at Morningstar. In some cases, she notes, that could be the result of one company that dominates a country’s market.
“Historically some of these large companies were government entities,” notes Oey, who adds that many such firms remain national “champions” that are favored by their governments and, at times, may put political interests ahead of profitability.
Even when a single company doesn’t overshadow an entire country, sector weightings can be an issue. “You have less sector diversification overseas,” says Alec Young, global equity strategist at S&P Capital IQ. He observes that foreign markets tend to have a bigger footprint in financials, energy and materials, while providing less exposure in health care, consumer discretionary and consumer staples.
Although the sector tilt varies from country to country, the information about weightings is readily available on the websites of ETF sponsors and the providers of the underlying indexes. “It’s pretty easy to get real-time daily updates of sector weightings,” Young says.
While the facts about sectors in indexes are easy to find, balancing the weightings in a portfolio with added single-country funds can be a chore. Indexing purists avoid the overlap problem entirely by limiting foreign stock exposure to the weightings in a major benchmark.
Advisors who employ a more active strategy can either outsource all foreign equity exposure to an active manager, or juggle passive ETFs to attain the balance they seek. Some of the complexity can be mitigated by using “capped” indexes that limit sector exposure.
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