From the October 2011 issue of Investment Advisor • Subscribe!

Use Country ETFs for Targeted Sector Exposure

A creative alternative to investing in industry sectors is through country ETF securities.

In recent years, investors have used ETF sector funds to achieve enhanced return potential based on fundamental and technical factors. The timing of investing in ETF sector funds is not always easy, but these securities have the potential to be rewarding if you are right on the fundamental and technical trends. 

With weak economic growth evident in the United States, is there another way for investors to participate in ETF sector funds? Global sector funds may be viewed as too broad and exposed to weakened economies in developed markets in Europe or Japan.

A creative alternative to investing in industry sectors is through country ETF securities. This is a way to gain a higher percentage exposure to specific industries or sectors that an investor may favor. Country ETFs may also provide investors with geographic diversification in their portfolios away from U.S. equities, with an added kicker of high concentrations in select sectors.

We decided to highlight two ETFs that reflect either defensive or commodities-driven investment themes. We also wanted our country ETFs to be in developed markets with high concentrations of multinational companies to take advantage of growth in emerging markets.

The iShares MSCI Canada Index Fund (EWC) has $5.5 billion in total assets, average daily trading volume of 2.9 million shares and an 8.23% return in the past 12 months. Its expense ratio of 0.53% is comparable to most international ETFs, but higher than U.S. ETF sector funds, which are in the 0.20% to 0.50% range. EWC has 103 total holdings, and the underlying index is the MSCI Canada Index.

According to Alexander Young, S&P international equity strategist, Canadian equities have been volatile this year, but have still outperformed most other international equity markets. While a weaker U.S. economy hurts Canadian exports, Young believes the Canadian economy will continue to hold up better than most economies. Canada’s largest banks had less exposure to the U.S. financial crisis and have stronger balance sheets. Canada is also a large exporter of commodities related to oil and gas as well as other natural resources and materials.

EWC’s three largest sectors are financials (32.0%), energy (25.8%) and materials (20.7%), and its top 10 holdings represent just below 40% of total assets. Its top 10 holdings include one stock with an S&P Equity Research ranking of five stars or strong buy, three with four stars or buy, three that have three stars or hold, and three that are not ranked. Applying S&P’s ETF ranking methodology, EWC has a marketweight ranking for each of the key measures of performance analytics, risk considerations and cost factors.

Diversifying your portfolio outside U.S. equities generally means having some investments in Europe, Japan or Asian developed markets. We selected the U.K. market as a defensive investment theme. We believe the United Kingdom is more attractive than the rest of the eurozone, because it has control of its destiny with its own currency. Also, the Bank of England’s policy since the start of the financial crisis remains accommodative, keeping its policy interest rate at 0.5% since March 2009, according to Jean-Michel Six, S&P economist. Many of its largest companies have growing exposure to emerging markets.

The iShares MSCI UK Index Fund (EWU) has approximately $1.3 billion in total assets, average daily trading volume of 2.8 million shares, and close to a 2% return in the past 12 months. Its expense ratio is also 0.53% (from BlackRock iShares), and it has 106 total holdings.

EWU’s two largest sector concentrations are energy (19.5%) and financials (19.0%), while its more defensive sectors approximate 34% of total holdings, including consumer staples (14.6%), health care (8.5%), telecom services (6.8%) and utilities (4.2%). Its top 10 holdings represent 46.6% of total assets. Its top 10 holdings include two five-star stocks, four four-star stocks, three three-star stocks and one that is not ranked. Applying S&P’s ETF ranking methodology, EWC has an overweight ranking for measures tied to performance analytics and risk, and a marketweight ranking for cost factors. 

Kenneth Leon is vice president and ETF analyst with S&P Equity Research. His research and writing on the ETF industry can be found on S&P’s MarketScope Advisor (http://advisor.marketscope.com), where this piece originally appeared.

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