From the March 2011 issue of Investment Advisor • Subscribe!

March 1, 2011

Growing Choice, Shrinking Globe

More investment options in global markets make the world a smaller place

Question: How do you invest in a country that you know has opportunity, but you’re not that familiar with? Or better yet, how can you get a piece of an industry in a particular country that you’re not familiar with, but that you know has a great investment theme behind it?

Answer: Via an exchange-traded fund (ETF), one of an increasing number of global ETFs that are so specific in nature they’re slicing the world into smaller and smaller bits. Thanks to burgeoning of the index-based global ETF industry, many of today’s country and sector specific ETFs are so narrow and so focused that they allow both advisors and investors to have an increasingly targeted and tactical approach to international investing. As such, these funds are able to tap into the very best opportunities that the global markets have to offer.

“Different countries and different regions develop at different speeds and oftentimes, a local story will have behind it a compelling investment theme,” says Adam Phillips, managing director at New York-based Van Eck Global, a pioneer in the ETF business.

ETFs, he says, allow investors to capture those many local stories and investment themes—investment themes that, in reality, investors should be making every effort to capture for the simple fact that they are the best opportunities out there.

“Whether we like it or not, 55% of the global market capitalization is outside the United States,” says Tom Lydon, president of Global Trends Investments and editor of etftrends.com, an online service that provides commentary and perspective on the ETF industry. “As a country, we are very under-allocated overseas, but if [investors] are going to be properly diversified in their portfolios, advisors just have to understand the numbers and get past the idea that making money is not just about investing domestically.”

Whether people are new to international investing or whether they want to hone and fine-tune their existing exposure, there are a plethora of ETFs for investors and their financial advisors to choose from to capture just about every kind of global opportunity. From broad, regional ETFs, which give investors diversified exposure to popular investment areas like the Middle East and North Africa (MENA) region or the hot markets of Brazil, Russia, India and China (the BRICs), to single country funds holding large-cap stocks, the opportunities are boundless, Lydon says. There are ETFs that invest in mid-cap and small-cap equity and offer a great chance to play on domestic growth in individual countries. Others have been constructed specifically to take advantage of the opportunities in particular industry sectors like infrastructure, consumer and financials, or a particular economic theme, such as the high price of commodities.

Today, all manner of global ETF products are enjoying tremendous success. In fact, Vanguard’s MSCI Emerging Markets ETF (VWO) and iShares’ MSCI Emerging Markets (EEM)—two of the largest diversified emerging markets ETFs on the market—have been in hot battles for assets, Lydon says, while country-specific products like iShares’ Brazil ETF (EWZ) and its Korea (EWY) and Taiwan products continue to see record inflows.

According to research done by ETF Trends, iShares’ MSCI Peru ETF (EPU), its MSCI Thailand ETF (THD) and Global X/InterBolsa’s FTSE Colombia ETF (GXG) were the top performers among single-country ETFs in 2010.

Lydon expects the ETF asset class to become even more popular going forward and he expects both the interest in and production of country- and sector-specific ETFs will increase as advisors and investors become more conscious of global investment opportunities. In fact, he believes that international and emerging market ETFs will increasingly steal the thunder from mutual funds that invest in the same asset classes and become the investment of choice for many.

According to the 2011 Investor Brandscape report put out by Cambridge, Mass.-based firm Cogent Research, that dynamic is already happening and more investors are actually favoring ETFs over mutual funds.

Cost has much to do with it, says Cogent Principal John Meunier. ETFs are much cheaper than mutual funds (Vanguard’s VWO has an expense ratio of 0.27%, by way of example, while iShares’ EEM charges 0.69%), he says, and many advisors feel that their clients should invest in products that achieve market performance at a lower price point.

“Right or wrong, advisors seem to believe that most active managers don’t beat their indices,” Meunier says, “and they’d rather save their clients’ dollars for those actively managed funds that really are top performers in their [respective] asset classes. Competition is therefore very tight and there’s a far greater scrutiny going on of mutual funds.”

While many of the large fund families have taken on the ETF challenge and have made it clear they’re not going to go quietly into the night, it is nevertheless quite clear, Meunier says, that advisors are very concerned about cost, not least because a large chunk of their compensation is fee-based. “So it’s an important incentive for them to find good products at low prices.”

ETFs meet that requirement, but more importantly than their price point, the increased specificity and customization of global ETFs allow for a more skillful and tactical kind of portfolio management, one that enables advisors to simultaneously take advantage of the potential in some areas of the globe while avoiding the pitfalls in others.

“Ten years ago, most advisors’ average portfolios would have had an international exposure of about 10% to 15%, but now it’s not unusual to see advisors recommending 40% in international exposure for their clients,” says Sue Thompson, managing director at iShares, one of the largest providers of ETFs in the world. “When you see that trend happening, you realize it makes sense for advisors to take a more deliberate approach and to be thinking about their international exposure in a more targeted fashion, which is why single-country ETFs are so attractive.”

Today’s global ETFs allow investors to, on the one hand, benefit from dynamics like high global copper prices and an imminent infrastructure boom that support investing in a country like Peru while also taking a tactical approach to countering a broader issue like rising inflation in emerging markets—an issue, Thompson says, that many advisors and money managers are concerned about, particularly with respect to India and China.

“If you are concerned about inflation rates in those countries, most broad emerging market ETFs have well over 20% exposure to India and China, so that particular product might not be where you want to be invested,” Thompson says. “You might want an emerging market product that just gives you exposure to Eastern Europe instead, such as ESR, iShares’ Emerging Markets Eastern Europe fund.”

The wide range of ETFs available on the market allow investors to mix and match to get the best out of their portfolio: “Let’s say you want to focus on commodity-producing countries because you think commodities will rise in price and are good hedges against inflation, you may buy single-country funds that give you that exposure, such as Australia (EWA) or Canada (EWC), and avoid single countries that are the consumers of commodities. This is the more sophisticated approach I see some advisors taking,” Thompson says.

According to Adam Patti, CEO of Rye Brook, New York-based IndexIQ, global ETFs are often best used as indirect plays on a hot investment story. Patti—whose ETFs are built upon proprietary indices—has rolled out ETFs that invest in Canada, Taiwan, South Korea and Australia, mainly because these four countries are China’s most important trading partners and China is arguably the hottest global investment story today.

“We believe that China has great growth opportunity, but the better way to get that growth opportunity is through investing in its largest trading partners, countries that are providing China with the goods and materials it needs to grow,” Patti says.

In keeping with the China theme, IndexIQ has plans to roll out, among others, ETFs for Singapore, Hong Kong and Taiwan, because “we want to own that whole Asia story.”

ETF providers like IndexIQ, iShares and Van Eck are creating new products based on in-depth research they’ve done on countries and markets, taking into account a large number of macroeconomic variables. But more importantly, their innovation is really the fruit of ongoing discussions with their clients—advisors and investors—and any new product they roll out is based to a large extent on what their clients are looking for in terms of investment ideas and products. Case in point: The move away from broader indices with bigger, multinational names to indices featuring small-cap stocks that allow for a better hold on local investment stories has been largely client driven, Thompson says. “This is why we launched our China small-cap product (ECNS), for example, because clients felt that our iShares FTSE Xinhua ETF (FXI) that tracks the China market has a lot of export-driven companies in it and they wanted to be able to invest in an ETF that would give them a view on the growth potential of the Chinese consumer.”

The evolution of the global ETF market and its increased customization can also be credited to the ongoing discussions between ETF providers and the makers of the many indices upon which ETFs are based. There has been a proliferation of indices as global ETFs have grown in number and become more specific, Patti says, and the flow of new product ideas has created a real opportunity for innovation and creativity by index makers.

But opportunity doesn’t come without challenge when trying to put together new indices that are getting increasingly granular for new countries or new sectors. The greatest challenge an index maker faces, particularly when constructing an index for a frontier market country or a particular sector within a frontier market, is the liquidity of the underlying securities, Patti says. “We put in very severe liquidity parameters when we’re building an index and even the smallest companies have to be liquid,” he says.

Liquidity is a key consideration for an ETF provider and one of the most important criteria taken into account when firms look at indices. ETFs can only be constructed on indices that are really made for the product, Van Eck’s Phillips says, and because indices are the backbone of an ETF, any investment idea, no matter how exciting it may be, can only come to fruition if the index on which it is built is investable, transparent and liquid.

It’s clear that both ETF providers and index makers are on the same page when it comes to index and product viability, but at the end of the day, as the global market gets more and more narrow, the true onus is on advisors and investors to make sure that they know everything there is to know about the ETF they’re investing in and its underlying index. This isn’t only for transparency and liquidity reasons, says Andy O’Rourke, senior vice president of marketing at Direxion Funds in Boston, but because “ETFs that look alike by name and are meant to be similar can also be very different,” and this can impact their performance.

As such, advisors and investors have to make sure they know these products very well because an ETF may have more exposure to a certain company, sector or region than its name implies. Market Vectors Russia Fund (RSX), for example, is 39.5% weighted toward the oil and gas sector, while iShares MSCI Switzerland ETF (EWL) has a 21% weighting in Nestle.

“At a minimum, I would say that people need to take a look at the sector weightings in the ETFs, because if there are only three sector weightings and one is highly represented, that would be a very different fund from one where there are seven or eight different sectors,” O’Rourke says. “Investors really need to know what they want from an ETF, whether they want to be narrow or broad, and they need to realize that not all Brazil funds and not all China funds are going to be the same.”

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