How You Can Own the Whole World

Most investors understand the value of diversification. All too often, though, investors in exchange-traded funds don't get the broad exposure they may expect. That's especially true for investors in international stocks.

But fund giant iShares is setting out to change that. In the process, it may solve one of the big problems that ETF investors have faced in trying to invest internationally.

How we got here
For much of the past decade, emerging-market stocks have given investors stellar performance. Especially when you compare returns with the lackluster results that developed-country stock markets gave investors, putting money in emerging markets was one of the best ways you could have invested.

As you'd expect, the success of emerging-market stocks led to more investor interest in them. Since that interest coincided with the time during which exchange-traded funds were getting more popular, ETF providers offered many ways to invest in emerging markets.

But the problem with many emerging-market ETFs is that they're highly concentrated. iShares MSCI Brazil ETF has more than a quarter of its assets invested in just two stocks: Vale (NYS: VALE) and Petroleo Brasileiro (NYS: PBR) . Similarly, the WisdomTree India Earnings ETF has roughly 40% of its assets in its top 10 holdings, with Infosys (NAS: INFY) and Tata Motors (NYS: TTM) both representing more than 5% of the portfolio. Those companies aren't bad in themselves, but Vale and Petrobras are highly linked to natural resources markets globally, while both Infosys and Tata rely on strong economies in their respective markets to drive growth.

Even broader-based ETF Vanguard MSCI Emerging Markets (NYS: VWO) focuses on the larger, more liquid stocks in emerging markets. The median market cap of the 900 stocks held by the ETF is a whopping $16.1 billion, with the top 10 holdings making up almost 19% of total assets. That leaves a big gap where a lot of small-cap exposure is missing.

Similar problems exist with many developed-country international ETFs as well. Especially with the rise of single-country stock ETFs, it's easy to end up with exposure that seems diversified but actually leaves you concentrated with large positions in just a few big names.

Fixing the problem?
In response to this, iShares decided to go the other direction from the overall trend toward specialization in ETFs, instead crafting indexes that will include thousands of different stocks. According to IndexUniverse, the company's new emerging-market fund will track an index that includes more than 2,600 different holdings that come from 21 countries and cover stocks of all sizes. Another fund designed to include securities from around the world will track an index with more than 8,600 different securities.

One thing to know about the proposed ETFs, however, is that they won't actually hold every stock in the indexes they track. Rather, iShares will do its best to track the indexes by choosing only a representative sample of the component stocks.

That decision leads investors to a trade-off. On one hand, the transaction-related expenses involved in buying and selling thousands of different stocks would make it very difficult for an ETF to be cost-effective, especially with fees becoming increasingly important in the competitive ETF industry. At the same time, though, representative sampling introduces the potential for huge tracking error if the statistical work underlying the sampling methods turns out to be flawed.

Not enough of a good thing?
Perhaps more importantly, adding hundreds or even thousands of extra stocks doesn't do much good if an index is weighted by market capitalization. For instance, the Vanguard Total Stock Market ETF purports to track the entire U.S. stock market, including both large and small stocks. But because of its market-cap weighting, less than 10% of its assets fall into the small-cap or micro-cap categories according to Morningstar. The new iShares ETFs may well exhibit some of the same characteristics when they come out, underweighting the desirable mid- and small-cap stocks that you can't really find anywhere else while owning plenty of the same stocks you'll find in other international ETFs.

Trying to own the whole world in your international portfolio by including stocks from a variety of countries and of varying sizes makes a lot of sense. But you may well find that the better way to add that diversification is through niche ETFs specifically tailored toward giving you small-cap exposure. That way, you can decide exactly how much diversification you really want.

Investing internationally is smart, but sometimes, the best stock prospects are closer to home. Take a look at three promising candidates in the Fool's latest special report, "3 Middle-Class Millionaire-Maker Stocks." It's free and waiting for you.

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Fool contributor Dan Caplinger loves international investing almost as much as he loves international travel. He owns shares of Vanguard MSCI Emerging Markets ETF. You can follow him on Twitter @DanCaplinger. Motley Fool newsletter services have recommended buying shares of Petroleo Brasileiro. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy works around the world.

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