About a year and a half ago, the partners of Steigerwald, Gordon & Koch in Leesburg, Va., had had enough. The firm had been using an actively managed fund for its international investments, says partner Jeff Gordon. Even after the financial crisis of ’08-’09, the firm loyally stuck with the portfolio managers, who shared the firm’s value philosophy.

“But once we got to 2010, 2011 some of their bets and some of their strategies just weren’t paying off.” The three-man investment team decided instead to look at international ETFs more closely. They were liquid enough that the firm felt like it could take a position without getting “caught up in it, per se.”

Gordon and his partners came up with a bucket of four different securities to get direct international exposure, the WisdomTree Emerging Markets Equity Income fund (DEM) fund, the iShares MSCI EAFE Value Index fund (EFV) for developed market value investments, the iShares Dow Jones International Select Dividend Index fund (IDV) for developed market yield exposure; and the iShares MSCI BRIC Index Fund (BKF) for exposure to BRIC countries. (The firm has $13 million in all these vehicles.) 

The debate over passive and active investing will probably go on forever—like arguments about politics and movies—but the international arena offers a rich tableau for partisans of both sides. How do you invest passively in a place like Europe, after all, where there are rich opportunities for single companies, but the overall market has made investors queasy amid the sovereign debt crisis and austerity? How do you invest with a broad brush in a place like “emerging markets” when the one giant country like China can see its GDP swoon, hurting global commodities and industry and blowing it for the rest of the asset class?

When the investing plays become so finely diced, and broad brush approaches can all go sour at once, many people might reasonably ask whether ETF plays are really the way investors want to go overseas.

Jim Holtzman at Legend Financial Advisors in Pittsburgh, says that he likes international ETFs because they allow you to focus on specific countries and regions without having to worry about global exposures. Instead you can make tactical bets and get in and out of markets quickly and nimbly. Still, the only international ETF exposure he has right now is in an iShares Mexico fund. He also sees compelling opportunities in Europe, but worries that a few bad headlines could torture the return. He also confesses that he worries about the proliferation of new ETFs that are very specifically focused—on single countries or sectors, for instance.

“Some of them are relatively new, some of them do not trade a lot, they don’t have a lot of assets as well, so if you’re a bigger firm like we are and we’re going to trade ETFs for a basket of clients within a certain strategy, we got to be careful we’re not moving the price whenever we’re making the trade.”

Tide In, Tide Out
Until recently, money had been lapping at emerging market shores for the past few years. The Vanguard FTSE Emerging Markets fund (VWO) and the iShares MSCI Emerging Markets fund (EEM) were both in the top five ETF money draws in 2012 (both taking in about $10.5 billion apiece), according to IndexUniverse. Funds focused on these countries have enjoyed great PR as many smaller governments in South America and Asia have strengthened their currencies with central bank discipline and growing middle classes. Because these countries have had more stable currencies and are cultivating a garden of consumers that can support domestic growth, investors have been giddy to invest in them.

But the optimism tempered this year, and the tide is out so far in 2013, and both the EEM and VWO funds are now in the top 10 of ETF redemptions so far this year, says IndexUniverse. Billions have flowed out of emerging market ETFs—about $4.85 billion from January 1 to May 31, according to State Street Global Advisors. The iShares MSCI Emerging Markets index was down 11% from January 2 to June 11. (Before that, it had more than doubled from its February 2009 nadir.)

Much of the damage has stemmed from the cooling growth of China. But the oxygen flowing out of emerging markets has been sucked up some by the developed markets, especially Japan and the U.S. and a convalescent Europe, where investor sentiment has been more sanguine.

International developed market ETFs, have seen $13.383 billion of inflows from the beginning of the year to May 31, according to State Street. Patricia Oey, the senior fund analyst on the passive research team at Morningstar, says she’s seen investors go back into Europe mainly because the concerns about the crisis have abated and valuations are attractive. “Many major European companies are very strong companies with global operations.”

“Europe’s got its problems, particularly a year ago,” says Keith Goddard of Capital Advisors Inc. in Tulsa, Okla. “It was priced for the end of the world and you got paid 5% while you waited if you used a dividend-weighted index.”

Until recently, anything Japan-related has been rallying most of this year after the country’s new president swore to increase inflation and the Bank of Japan introduced more aggressive quantitative easing to deflate the yen and spark its export industry (the trend cooled off big-time in May, however). The resulting market rally, Oey says, allowed the WisdomTree Japan Hedged Equity fund (DXJ) to rise 50% between June 2012 and June 2013—and with huge fund flows, it exploded from $600 million in assets last year to $9.345 billion in assets in May of this year. But the hedge component was extremely important, she says, because of the falling yen.

“The best performing international equity funds in terms of categories,” says Oey, “was anything Japan-related, either hedge products where the currency effects were hedged out or even unhedged products were very popular as well.

“Southeast Asian funds also did very well,” she says. “Those economies for investors seem to be relatively more attractive maybe compared to the larger ones like China and Brazil and Russia and India. Countries like Indonesia Thailand, [and the] Philippines.” These countries were less scathed by the financial crisis, she says. “They have some good tailwinds; they have relatively young populations. Their governments are looking to spend more on infrastructure. So the growth and outlook is pretty good. Fund flow into single-country ETFs helping those countries has been pretty strong as well.”

Dividend Funds
The story for international ETFs is currently the story of trends in the broader ETF world—which has seen greater demand for high dividend plays and low-volatility plays.

With low interest rates in the U.S., many investors have been on a hunt for higher yields to help them meet their short-term money obligations. At the same time, they don’t want to take on the risk of holding bonds when interest rates rise. These troubles have made dividend funds a likely play, especially overseas where payouts are traditionally higher.

Not surprisingly, international ETFs with a dividend bent have seen huge net inflows this year: $3,932 billion, according to IndexUniverse, for a total of $13,496 billion in assets under management by the end of May.

Three of the big ETF companies already have a presence here: the WisdomTree Global Equity Income fund (DEW), which has a 3.75% 12-month yield; the First Trust Down Jones Global Select Dividend fund (FGD), which boasts a 4.94% 12-month yield; and the Guggenheim S&P Global Dividend Opportunities Index (LVL), which boasts a 7.18% 12-month yield.

No to be outdone, State Street joined the fracas at the end of May with its own new fund, the SPDR S&P Global Dividend ETF (WDIV), which mirrors the S&P Global Dividend Aristocrats Index, a slate of about 100 companies chosen for their ability to grow and maintain their dividends every year for 10 consecutive years (and which can get kicked out of the index if they don’t).

“What’s interesting about international dividend investing,” says David Mazza, a vice president of State Street Global Advisors and head of the firm’s ETF Strategy in the Americas, “is the yields tend to be more attractive outside the U.S.” According to State Street, the yield on the S&P 500 was about 2.03% as of June 4, while it was 3.19% on the international developed index (the MSCI EAFE) and 2.75% on the international emerging markets index (the MSCI EM). On the S&P Global Dividend Aristocrats index, the basis of the new product, it was about 4.73%.

The proliferation of dividend funds and country-specific funds have allowed some financial advisors to base whole strategies around them. Goddard of Capital Advisors says his firm uses international ETFs in three ways.

“We do use fundamentally weighted international ETFs that are dividend oriented,” says Goddard, co-portfolio manager of the TacticalShares Dynamic Allocation Fund (TGIFX), as well as Capital Advisors’ CEO. “We use country-specific ETFs in a public mutual fund that we manage. And then we have a couple of generic EAFE MSCI emerging market type exposures as well.” The firm’s clients in the accumulation phase with a long time horizon are put in the standard passive indexes, and those in distribution phases, including retirees and endowments and foundations with spending policies, are skewed toward dividend-weighted approaches.

In addition to its domestic and natural resources exposure, the TacticalShares mutual fund includes country-specific funds that tactically move in and out of ETFs based on moving average signals. “In that fund we are going down to the level of the country, so we have 15 developed market countries and 15 emerging market country ETFs inside that strategy.”

“When you’re in a trend following investment discipline, it’s nice to not have to be either in international or out of international,” he says. “It’s nice to be either in five to 15 countries or seven to 15 countries or all 15, depending on whether the global markets are trending positively or negatively.” If any of the 15 countries slip into a negative trend defined by the moving average, he says, the firm gets out and stays out until the trend turns positive.

Minimum Volatility Funds
Though dividend funds are making huge gains, they are being challenged by the rock star rise of low volatility funds in the international ETF space. These funds include index companies with the fewest fluctuations in share price over some period, say the last 12 months, using measurements like standard deviation and minimum variance. According to IndexUniverse, these funds have seen $2.25 billion in inflows this year, totaling $4.137 billion in assets by May 31.

Among the largest such funds are several iShares products, the MSCI Emerging Markets Minimum Volatility fund (EEMV), which has seen inflows of $1.3 billion and is now at $2.2 billion in assets, and the iShares MSCI All Country World Minimum Volatility fund (ACWV), which has seen $328 million in inflows and is now at $1.042 billion. PowerShares low volatility funds in the international space have also seen big inflows. All while emerging market ETFs on the whole were losing money.

“Those funds have done really well,” says Morningstar’s Oey. “Something like the iShares emerging markets minimum volatility product, in one year from April to April went from $148 million in assets to $1.9 billion in assets—so over 10 times. That includes capital appreciation, but a lot of that is fund flows.”
The argument for these funds is that those investors who take on less risk eventually outperform, though they might lag in up markets. Goddard says low volatility is a great idea, but he worries about the space getting bid up by investors crowding in, since he believes a lot of these investors are going to be buying into the same names—blue chip companies already getting goosed forward by the high-dividend crowd.

“When they get bid up to excessive prices as junk bonds did in the late 1980s, it goes too far and you wait until the maximum number of people get in at the top and then it falls apart,” he says. “I don’t think we’re there yet, but I think we’re getting there. Dividend-paying stocks are in many cases the same stocks that are in these low volatility portfolios, so you have this dual feedback loop going on where people are chasing income and they are chasing low-vol strategies, both of which put you into Johnson & Johnson and Merck and Coke and the same stocks. If this goes on much longer, we could be back to paying 29 times earnings for Coke and waiting 12 years to get your money back.”

Anthony Parish, a CFA at Sage Advisory in Austin, Texas, says his firm has a 20% international exposure on its equity side. When it comes to international investing, Japan and the U.S. seem to be the places to be right now, giant economies subject to the greatest amount of central bank stimulus activities. “There are times to fight the Fed, or fight the central banks, and given the magnitude of what’s going on in the U.S. and Japan, it just doesn’t seem like this is one of those times.”

He says Sage, which has $3 billion in ETF strategies, tends to keep a tight list of investments, six to 10 holdings, with large positions that rarely fall under 5% of holdings. “A 5% to 10% position on $3 billion worth of assets is a large amount of inflows if we are selling out of or buying into a fund.” That means the firm tends to stay with the big ETF names, the ones with the most transparency whose markets it won’t like move by selling. The firm also eschews more esoteric stuff like country-specific funds or inverse funds or other things Parish calls “gimmicky.”

Because the bias is definitely on Japan and the U.S., which he says makes the portfolio look somewhat unexciting. “We’re not going into spicy or obscure countries or territories,” he says.