WHEN THEY WERE FIRST

introduced as WEBS ("World Equity Benchmark Shares"), back in the mid-1990s, most single-country exchange-traded funds were ignored by pros and amateurs alike. Volumes were low, spreads were wide and with the U.S. markets soaring, owning overseas stocks was largely seen as a sucker's game.

How times have changed.

now renamed iShares are among the hottest trades on the board.

Foreign ETFs essentially provide investors a convenience. Rather than sift through tons of ADRs or non-U.S. pink sheet stocks using sites from Bank of New York or J.P. Morgan, foreign ETFs package a country's most liquid and highly capitalized names into one simple trade.

But convenience always comes at a cost. And one of the problems with ETFs, which we first discussed more than four years ago, is that they tend to focus on the largest, most widely owned stocks. At a time in which smaller-cap stocks, even internationally, continue to outperform their larger-cap brethren, this can have a debilitating effect on returns. The small-cap S&P 600 is up 7.68% over the past 12 months. The S&P 500 is up only 2.84%.

One of the other big problems with ETFs is that they simply don't exist for many of the emerging markets where economic (and stock-market) growth is most pronounced. For example, Indian stocks have soared in recent months, and because there is no ETF that focuses on India, the few closed-end funds that own stocks in the region are trading at extremely rich premiums to their underlying net-asset values. India Fund and Morgan Stanley India Investment Fund are both exhibiting strong upward momentum, but trade at almost absurd premiums to their underlying NAVs. Morgan Stanley's offering is trading 13% over its underlying NAV, while the India Fund is almost 30% over NAV.

In this case, my strategy for adding exposure to India would be to pick out the underlying stocks, such as ICICI Bank or Tata Motors Limited, held in the funds, or opt for any one of the open-ended funds that own Indian issues. With offerings like Matthews India Fund or Eaton Vance Greater India, you'll give up the intra-day liquidity of the closed-end funds, but get much more efficient use of your investment dollar or rupee.

For my money, the best odds in the market come when you choose the road less traveled. And these days, when it comes to foreign investments, that means concentrating on assets beyond the obvious large-cap stocks...even the foreign ones to which the herd is increasingly attracted.

Whatever Floats Your Boat

For example, I've had good success lately with Blackrock Global Floating Rate Income Trust, a closed-end fund that owns foreign securities, but not stocks. Regular readers of Tradecraft are familiar with floating-rate, or bank-loan, funds, which I've mentioned regularly since first profiling the asset class back in 2003. Unlike traditional bonds, which pay a fixed interest rate over a specific period of time, the loans held in bank-loan funds' portfolios float, meaning that they periodically reset based on a benchmark interest rate, such as the prime rate or the London Interbank Offered Rate (Libor). The Blackrock Fund is unique because, unlike other funds in the asset class, it focuses on the non-U.S. issuers very much in vogue as of late. It pays monthly dividends at an annualized rate of 7.68% and is currently trading at a 6.85% discount to its NAV. The herd ain't here...yet.

The only other fund even remotely similar is Salomon Brothers Emerging Markets Floating Rate Fund, which owns only floating-rate government debt from many of the world's biggest credit risks. Russia, Brazil, Morocco and Panama are among the fund's top 10 holdings it's yielding 6% and trading at a 13% discount to its underlying NAV. For the more traditional fixed-income investor, the loan participation asset class offers somewhat of a hedge: Both funds' payouts should rise if short-term interest rates continue their upward climb.

Investors are increasingly comfortable with the notion of holding foreign stocks. But how many have yet taken the step to actually own some of their currency? Another, less obvious way to participate in foreign markets is via the Euro Currency Trust, a new currency-based ETF that we profiled a few weeks back.

Euro Rising

The foreign-currency market is enormous, trading almost $2 trillion each day, far surpassing both the stock and bond markets. Because it involves making a bet on the European currency, not European stocks, FXE allows the average investor to trade a market that previously only multinational banks and other institutional players could access. A long position in FXE is a bet on the euro: If the euro strengthens relative to the U.S. dollar, then the price of FXE will rise. If the euro weakens, it drops.

Because it's a separate asset class altogether, adding a position in FXE helps to diversify a portfolio beyond simply stocks. That's important, because despite the fact that foreign markets have outperformed U.S. stocks, they're all generally still highly correlated assets. When the German Dax rises, so does the Dow.

Moreover, beyond the benefits of diversification, both technical and fundamental analysis suggests that a short position in the U.S. dollar could end up a winner in 2006. Precious metals, usually correlated with a weak dollar, are spiking, and after rising through most of 2005, the U.S. dollar index has so far stumbled this year. More than a few economists are suggesting that America's increasingly onerous entitlement burden of Social Security and the prescription drug plan will translate into a debased currency. Currencies tend to trend for long periods of time, and if the dollar decline continues, this under-the-radar play could get quite popular in a hurry.

As the saying goes, the three rules of real estate are "location, location, location." And while the pundits debate whether or not the U.S. real-estate market is a bubble about to burst, a global real-estate fund could be a beneficial way to add non-U.S. exposure in risk-controlled fashion.

While securitizing real estate into REITs and other exchange-listed formats is common in the United States, it is still relatively novel in most parts of the world. Cohen & Steers Worldwide Realty Income seeks to take advantage of that opportunity, investing some $446 million into shopping centers, office, industrial and residential real-estate companies across the globe. Although some 39% of the fund's assets are invested within the U.S., only a few of the fund's top 10 holdings are domiciled here. Issues such as Westfield Group (Australia), Rodamco Europe (Netherlands) and Deutsche Wohnen AG (Germany) aren't even listed in the U.S., making the fund a unique vehicle to get access to companies that don't offer an ADR program to U.S. investors. The fund yields 7.5%, pays monthly dividends and trades at a 5% discount to its underlying net-asset value.

Hot Properties

A similar offering ING Clarion Global Real Estate Income Fund, which also boasts investments in various international real-estate operations, although the vast majority of its holdings some 60% are domiciled here the U.S., largely negating its value as a foreign diversifier. Europe's Wereldhave and Australia's Westfield group are large holdings, but so are domestic issues such as Heritage Property Investment Trust and Liberty Property Trust. The fund's 8% dividend yield and 8.30% discount to NAV might interest value-oriented investors, but those seeking more pure foreign exposure might consider Alpine International Real Estate Fund, an open-ended fund with virtually all of its assets invested offshore. The fund, which we called "one of my favorite things" back in 2002, has boasted double-digit returns for the past three years running.

Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC. At the time of writing, Hoenig's fund held positions in many of the securities mentioned.