Developed Ex-US ETFs?

As you position the global portion of your portfolio for 2014, you may be forgetting about our northern cousins.

The developed markets of the world had a much better year than their emerging market brethren. And, if you’re considering riding the developed-markets wave, it’s also worth considering whether Canada belongs in your portfolio.

The most popular developed markets ex-U.S. ETF on the market is the iShares MSCI EAFE fund (EFA | A-89). The fund has $50 billion in assets, trades at pennywide spreads and tracks the widely followed MSCI EAFE index.

The problem is that the fund completely ignores our North American neighbor, Canada. Like many developed ex-U.S. strategies, EFA lumps Canada in with the U.S. This is no fault of iShares, of course. The EAFE in the index’s name stands for Europe, Australasia and Far East.

The problem with this approach is that it forces investors to make a choice: Invest in a fund like EFA and obtain exposure to Canada through something like the iShares MSCI Canada (EWC | A-94), or you can go on believing Canada is actually part of the U.S. If the latter is the case, if you own the SPDR S&P 500 ETF (SPY | A-98) or the iShares Russell 3000 ETF (IWV | A-100), you can simply check North America off your list.

The ‘Peaceful Kingdom’ Is Not The U.S.

The problem with this line of thinking is that it assumes Canada has the same pattern of returns as the U.S.

But no matter how you slice it, this is not the case.

The correlation of the Canada-focused EWC to the Russell 3000 ETF “IWV” over the past two years is 0.78. Further, the makeup of the Canadian market is distinct from both that of EFA and IWC.

Let’s take a look at the sector profile of the three funds:

Source: IndexUniverse

Clearly, the Canadian market is much heavier on energy and basic materials than both the U.S. and EAFE markets. This should come as little shock to investors familiar with the abundant natural resources of Canada. But it also shows just how distinct the country is.

Investors seeking a complete global portfolio should therefore consider the Schwab International Equity ETF (SCHF | A-92). It’s a developed-markets fund that excludes the U.S. while still including Canada, which makes it perfect for our purposes here.

Not only does the fund have an ultra-cheap annual expense ratio of just 9 basis points a year, or $9 for each $10,000 invested, it’s also liquid enough to accommodate most investors.

Spreads are wider than those on EFA—6 basis points versus 2 basis points—but investors more than make up for that by avoiding paying some blend of EFA’s expense ratio of 34 basis points and EWC’s of 53 basis points.

I would be remiss if I didn’t mention that SCHF tracks a FTSE index, which means Korea gets lumped into SCHF’s portfolio. As such, investors using an MSCI-based emerging markets product run the risk of unknowingly overweighting South Korea if they add SCHF to their global basket.

To be totally clear, the problem here is that FTSE doesn’t classify South Korea as an emerging market anymore, but MSCI still does.

Nobody said it would be easy.

As with any choice, your decision on which developed ex-U.S. ETF should take into account the entire investment allocation.

That said, assuming Canada is irrelevant to your global equity exposure, or ignoring the country altogether, breaks one of the main tenets of indexing: portfolio completeness.

At the time this article was written, the author held no positions in the securities mentioned. Contact Paul Baiocchi at [email protected].