On average, international stocks appreciate more than US stocks and stocks in countries with the most economic freedom appreciate more than the international average. The MSCI EAFE International Index gained 26.6% during the one-year period ending June 30, 2006 and averaged 23.9% annually for the past three years. Stocks in the ten most economically free countries gained 24.5% during the past year, averaging 27.3% annually for the past three years.

For small accounts, investing in a good international fund is sufficient diversification. Greater diversification and returns can be gained by putting some funds into emerging markets which appreciated 35.5% over the past year and averaged 34.3% over the past three years. Emerging market returns were exceptional due in part to Brazil, which posted gains of 64.9%. Although emerging markets typically do better than other international stocks, they are inherently more volatile.

To balance performance and stability, a simple foreign asset allocation might invest two-thirds in the MSCI EAFE Foreign Index and one-third in the MSCI Emerging Markets Index. Using this technique, you would have gained 29.5% for the past year and averaged 27.4% over the past three years.

For larger accounts, a more complex asset allocation should be used. This asset allocation strategy takes advantage of the fact that economic growth is often better in those countries with the greatest economic freedom. We use the Heritage Foundation’s measurement of economic freedom to emphasize those countries that combine the greatest economic freedom with large investable markets.

According to the Heritage study, “Economic freedom is defined as the absence of government coercion or constraint on the production, distribution, or consumption of goods and services beyond the extent necessary for citizens to protect and maintain liberty itself. In other words, people are free to work, produce, consume, and invest in the ways they feel are most productive.”

A country’s economic freedom score is based on fifty measurements that fall under the following categories: trade policy, fiscal burden of government, government intervention in the economy, monetary policy, capital flows and foreign investment, banking and finance, wages and prices, property rights, regulation, and informal market activity.

Several of the twenty countries to receive a “free” ranking have easy, convenient, and inexpensive ways of investing in the market using country-specific iShares stocks. iShares are exchange-traded funds (ETFs) which combine the liquidity of individual stocks with the diversification of index funds. The iShares Funds also have lower expense ratios than most mutual funds.

Since its inception in 1994, the Heritage Foundation Index of Economic Freedom has used a systematic, empirical measurement of economic freedom in countries throughout the world. The conclusions from this study clearly demonstrate that countries with economic freedom also have higher rates of long-term economic growth. That makes the study useful for investors to decide which countries should be emphasized in their foreign stock allocation.

For larger accounts, we invest half of the assets using the simple technique described above. As such, one-third is invested in the MSCI EAFE index (EFA) and one-sixth in emerging markets. The other half is divided evenly among the ten countries with the most freedom that also have markets large enough to have a country-specific exchange-traded fund.

The top ten most economically free countries all beat the United State’s 8.2% return. In descending order of the past year’s returns were Canada at 31.6% , Germany at 30.0%, Switzerland at 29.6%, Austria at 28.7%, Sweden at 27.2%, the Netherlands at 23.1%, Singapore at 21.2%, the United Kingdom at 20.9%, Australia at 20.6%, and Hong Kong at 12.1%. Over the past year, five of these countries beat the MSCI EAFE Foreign Index and five fell short.

The EAFE Index did well in part due to Japan’s stellar 35.9% returns. Normally, we don’t recommend specific investments in Japan. While this year has been good, Japanese returns averaged a 0.1% loss over the last ten years.

This year however, Japan’s economic freedom score rose significantly, making Japan the 27th freest country. Japan’s recent 35.9% return and 25.1% three-year average suggest that the Japanese economy may be rebounding from its malaise.

Averaged together, the top ten “free” countries gained 24.5% this past year and averaged 27.3% over the past three years. While Japan’s returns over the past year brought the international index up, over the past three years investing in the ten countries with the most economic freedom surpassed the EAFA Foreign Index by an annual 3.3%.

Diversifying your foreign investments is just one important component of an optimal asset allocation. Building balanced portfolios that are more likely to meet your financial goals doesn’t happen casually or by working with someone whose interests are in conflict with yours.

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