Fool.co.uk - Investments

Most Fools seem to agree that having at least a portion of investments in index trackers is not a terrible idea. The question that always comes next though is 'What should we track?'

But before I get into that, let's try to remember why we choose index trackers. OK, we're all different, but I expect most people like to track because:

• It's an easy and cheap way to invest for the long term;
• It gives you an instantly diverse (i.e. relatively safe) portfolio; and
• It's a simple way to be reasonably confident of getting real returns (i.e. beating inflation) and of beating cash and bonds over the long term.

Our reasons for tracking foreign markets

However, if you're considering investing in foreign trackers, I bet it's for a fourth reason -- you believe you can improve your returns. If this is the case, you're no doubt looking just at emerging markets and markets that have performed relatively badly in recent years (in the hope that they will bounce back).

To me, this is the total opposite of the reason that most people track the UK market. You're making a real investment decision much like picking individual shares. It goes without saying that anyone who wants to use foreign trackers to beat bog-standard UK ones will have to consider more exotic things -- with all the associated risks that go with the higher possible returns. 

We should ask ourselves whether tracking foreign indices will:

• beat cash and bonds in the UK?
• increase our chances of getting significant real returns?
• add much needed diversity?
• add too great a currency risk?
• be too expensive?

1. Will we beat cash and bonds in the UK?

Over the long term this seems likely, based on data going back to 1900. However, based on the same data, it seems at least equally likely that tracking the FTSE All-Share (news) or FTSE 100 will beat cash held in sterling accounts and sterling-denominated bonds; we earn and spend in pounds, so that should be our chief concern.

Over the long term, stock markets have provided a much stronger return versus bonds or cash in the same currency. That has been shown by some very thorough research into 17 stock markets, not least of which in Dimson et al's Worldwide Equity Premium report.

2. Will it increase our chances of getting significant real returns?

It's not all about beating cash and bonds. The real returns also have to be high enough to justify the extra risk taken when investing in shares, and to give you a pot at the end that is satisfactory. Historically, the UK has performed around the world average, in real terms, which will be good enough for most people.

We also have one of the most consistent records. The longest we've gone (so far!) where we haven't made real returns was 22 years, and that was very unusual. However, other countries haven't been so lucky. Some have experienced real losses for periods as long as 50 years. Assuming you don't think the UK is immune to such events, this is an argument for ensuring we're not reliant totally on the UK.

3. Will it add much needed diversity?

On that note, you may be thinking you need to spread your wings. However, London isn't seen as a major global financial centre for no reason. A vast amount of the profits from companies listed in London come from overseas. Dozens of blue chip companies have huge operations overseas. It's easy to find individual examples. Anglo American (LSE: AAL.L - news) (LSE: AAL) , SABMiller (LSE: SAB.L - news) (LSE: SAB) and Standard Chartered (LSE: STAN.L - news) (LSE: STAN), for example, all get more than 50% of their profits from foreign countries.

The UK's stock market is globally diverse already. If you decide to track other markets, you need to believe that the UK's market is still not diverse enough.

4. Will it add too great a currency risk?

Almost all my opinions in this article are based on the research of just three professors: Dimton, Marsh and Staunton of the London Business School. Their contribution to equity studies has been the most thorough and of the highest quality. They are responsible for many independent studies and also for writing possibly the most respected annual report into equities, the Global Investment Returns Yearbook, most recently sponsored by CSFB.

Amongst the piles of paperwork they have generated, these researchers have conducted the most meticulous analysis of currency risk that I have seen. Their findings are promising. They wrote in 2006 that, while short-term falls in a currency's strength can seriously impact short-term returns, exchange-rate movements have mattered much less to long-term investors. Parity (LSE: PTY.L - news) changes have largely tracked relative inflation rates. Real (Frankfurt: BJU.F - news) exchange rates, after adjusting for differences in inflation rates, have changed at most by just a fraction of 1% per year.

5. Will it be too expensive?

The costs of index tracking are getting very low. Some international trackers are even cheaper than UK ones, as revealed by Padraig O'Hannelly in this article. It lists almost 80 trackers and their costs (the total expense ratios).

Picking trackers

In summary, if you're tracking for the three reasons I set out near the beginning, it makes sense not to choose a foreign market deliberately because you think it'll outperform. Instead, you want to track both some emerging and developed markets to get a wide spread.

However, on the evidence I've found, the case for tracking foreign markets is not very strong unless you wish for more than just diversity, real returns and beating cash in a sterling savings account. Therefore, you might still want to keep most of your money in UK trackers unless you're also looking for outperformance.

Those of you looking to outperform by investing globally should read Malcolm Wheatley's Go Global For Greater Gains.

> The Motley Fool Share Dealing service is at your disposal. UK trades cost £10 and overseas trades £17.50. It's free to open an account.