From the September 2009 issue of Investment Advisor • Subscribe!

September 1, 2009

The ETF Advisor: Pick a Country, Any Country

Investing Internationally With ETFs

The rally in foreign and emerging market stocks during the first half of 2009 has awakened within U.S. investors an apparently long slumbering desire to invest in countries such as Colombia and Malaysia. Barclay's iShares, the world's largest ETF sponsor, spent the first six months of 2009 racing against newcomer Global X Management to list the first ETF tracking stocks from Peru. (Barclays won the race in June, when shares of its MSCI All Peru Capped Index Fund (EPU) started trading.)

There are about 40 "country-specific" ETFs which track local stock market indexes at relatively low cost, listed in the U.S. There are no less than 10 ETFs that track Japanese stocks--from broad-based funds such as the iShares MSCI Japan Index fund (EWJ) to specialized funds like the WisdomTree Japan SmallCap Dividend Fund (DFJ)--and six focused on China, including funds targeting Chinese small cap stocks and the real estate sector (FXI, EWH, GXC, PGJ, HAO, FCHI). Just one country specific fund--iShares MSCI Switzerland Index Fund (EWL)-has Standard & Poor's top "Overweight" ranking, which is based on a blend of performance, risk, and cost factors.

For those that prefer a focused, rather than scattershot, approach single-country funds offer an attractive proposition. For roughly the same cost as investing in a U.S. sector ETF, investors can gain exposure to markets from Belgium (EWK) to Brazil (EWZ) through a security that trades on a U.S. exchange during regular business hours. And while many foreign companies are listed in the United States as American Depository Receipts and Shares, country-specific funds give exposure to smaller, lesser known companies that are too small for a U.S. listing.

The downside to country-specific funds is that, like the economies they are based on, many are heavily weighted to a particular economic sector. Global X's first fund, the InterBolsa FTSE Colombia 20 ETF (GXG), has almost half of its assets in banks or financial services. The iShares MSCI Mexico Investable Market Index Fund (EWW) is 38% invested in telecommunications.

Standard & Poor's Equity Strategy recommends U.S. investors seeking to build global equity ETF portfolios use passive, low cost, broadly regionally diversified international ETFs as the core building blocks of their overseas equity exposure.

"This approach allows investors to capture the risk reducing benefits of diversification while simultaneously minimizing trading costs by reducing both the number of ETFs needed as well as the need to constantly rebalance country weightings within the portfolio," explains Alec Young, S&P's international equity strategist. "With broadly geographically diversified international ETFs, the index provider handles country level rebalancing for the investor, a key advantage not present when investors build their own country level portfolios."

Overall, while individual country ETFs can also be used in accentuating exposure to a timely trend or secular theme, their lack of diversification and inherently higher risk profile means they should be limited to smaller satellite allocations that complement larger, more geographically diversified core holdings, Young says.

"Building an entire global ETF portfolio using only country level ETFs substantially raises trading costs and benchmark risk as most individual investors omit smaller, lower profile countries that collectively can represent sizeable portions of major international equity benchmarks," he says.

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