International Mutual Funds

Nearly all of the mutual fund families offer multiple funds that are geared toward international investing. The different kinds of funds can be categorized into index funds, international funds, regional funds, country funds, emerging market funds, and global funds. International mutual funds have higher expense ratios than domestic mutual funds to cover higher trading costs and higher management fees. The funds also tend to have redemption fees to control frequent trading. Examples of funds offered by major mutual fund companies are given below.

* Index funds. These include Fidelity Spartan International Index Fund, Vanguard Developed Markets Stock Index, Vanguard Emerging Markets Stock Index, and Price International Equity Index Fund.

* International funds. These funds do not invest in the domestic market. Funds include Fidelity International Growth, T. Rowe Price International, Fidelity Overseas, Vanguard International Growth, Fidelity Diversified International, and so on.

* Global funds. These funds invest in all countries, including the domestic market, and include Templeton World, GT Global Worldwide, Dreyfus Global, Vanguard Global Equity, Price Global Stock, and so on.

* FundsRegional funds. Examples include Fidelity Europe Capital Al preciation, Fidelity Nordic, Vanguard European Stock Inde and T. Rowe Price European Stock.

* Country funds. Examples include Fidelity Canada and Fidelity Japan Smaller Companies.

* Emerging market funds. Examples include Fidelity Emergin Markets Fund, Fidelity Latin America, and T. Rowe Price Emerging Markets Stock.

Exchange-Traded Funds and Closed-End Funds

Both exchange-traded funds (ETFs) and closed-end funds trade o organized exchanges, just like stocks. Unlike mutual funds, which are priced at the end of the day, ETFs and closed-end funds can la traded at any time during trading hours with no restrictions or re demption fees.

Closed-end funds were started several decades ago, when many markets were closed to foreign investment. For example, Scudder Investments was permitted to invest $100 million in Korea in Apri 1984 with the condition that the money could not be taken out of Korea, nor more money brought in. As a result, the fund cannot redeem shares nor issue more shares. In other words, it is a closed- end fund. Any shareholders of the Korea Fund can sell shares only on an exchange, like the NYSE. Similarly, new investors must buy shares on the NYSE. One problem with the closed-end funds is that they usually trade at a discount (sometimes at a premium) to the underlying value of the securities held. The reasons for the discount/ premium are not well understood, so many investors tend to avoid closed-end funds.

Exchange-traded funds track an index by holding the stocks in that index. There are iShares for twenty countries that track the MSCI (Morgan Stanley Capital International) country indexes, and three regional indexes. The regional ETFs are for the Pacific except Japan, EAFE, and the EMU. The EMU fund is for countries that participate in the euro. In addition to the ETFs that track MSCI indexes, there are four ETFs that track S&P international indexes: Latin America, Topix (Japan), Europe, and Canada. The ETFs track the underlying indexes quite well, with a correlation of about 0.97. At the same time, the correlation of ETFs with the S&P 500 is low. Thus, ETFs are effective in diversifying the risk of a domestic portfolio.

The expense ratio of the ETFs is less than 1 percent, which is less than the expense ratio for mutual funds. However, there are other costs of trading ETFs such as brokerage commissions and the bid- ask spread. Unlike the popular ETFs such as SPY (for the S&P 500) and QQQ (for the Nasdaq 100), international ETFs may not be actively traded. Investors may not want to trade ETFs if the daily average volume is less than a hundred thousand shares.

Multinational Companies

The last possible avenue for obtaining international exposure is multinational companies with large overseas operations. As these companies operate globally, their stocks should provide the diversification expected from foreign stocks. However, research suggests that multinational companies are not good substitutes for foreign investing.

The failure of multinational companies to diversify risk should not come as a surprise once you consider the correlation between the S&P 500 and companies with large overseas operations.

Correlation with Company S&P 500

General Electric 0.97

Merck 0.96

Exxon Mobil 0.96

Pfizer 0.96

Microsoft 0.96

Chevron Texaco 0.94

Dell 0.93

AI Group 0.93

Citigroup 0.93

Intel 0.92

A correlation of more than 0.90 means that there is unlikely to be significant improvement in risk by the addition of or overweighting of these companies in a domestic portfolio.

Effectiveness of theses Instruments in Diversification

Though the ADRs and ETFs do not span the entire spectrum of foreign markets, they help in substantially diversifying risk. The addition of international mutual funds to ADRs and ETFs almost fully captures the benefits of international investing, eliminating the need or an individual investor to invest overseas directly.

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