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Assessing the Impact of Dubai's Default on ETFs

United Arab Emirate companies are no small part of Middle East-themed ETFs.

Scott Burns, 12/03/2009

On Nov. 25, Dubai shocked the world by saying that it would not backstop the development corporations and conglomerates that helped fuel the city's rapid rise from modest regional power to an international destination for trade and tourism. The announcement highlighted just how far afield the real estate bubble had spread, as the city renowned for its engineering achievement and excess--think palm-shaped island development and 25 story tall indoor ski resort--could no longer support its massive debt load.

Although it is rare that the average U.S. investor will have any direct investments in companies listed in Dubai's home country of the United Arab Emirates, there are a handful of ETFs that have exposure to those names. The ETFs with the largest exposure to UAE-listed companies traded off sharply on the news. An announcement like this is huge and will have a major impact on how international investors view the local market, especially when, by all appearances, the majority of the UAE-listed holdings in these funds are financial-services companies.

Caught in the Storm
The largest holder of UAE listed names is Market Vectors Gulf States MES with 25.6% of its assets in UAE-listed stocks. This ETF dropped nearly 8.7% between when the announcement was made on November 25 and the market close on November 30.

Next on the list, PowerShares MENA Frontier Countries PMNA is actually more broadly diversified across the Middle East and North Africa, but its exposure to the UAE is the largest of its country exposures, clocking in at 22.1% of its holdings. In the two trading days following the announcement, this fund dropped 5.7%.

Our final major holder of UAE companies is WisdomTree Middle East Dividend GULF with 18.8% of its portfolio in the UAE. While this ETF may have the least amount of exposure of the three to the UAE, it has taken the heaviest damage of the bunch dropping 9.5%. We theorize that this ETF is more concentrated in financial-services companies in the UAE than the other two ETFs. Still, in aggregate, GULF has far less exposure to financial services overall than both MES and PMNA (40% versus 63% and 57%, respectively), so it is worth keeping an eye on how Dubai's default might spread through the region's financial system. PAGEBREAK

Frontier Market Investing
One thing worth noting is that, overall, these funds are relatively small in terms of assets under management averaging around $10.5 million. So we don't expect this to cause widespread problems in the portfolios of U.S. ETF investors. Still, this highlights once again the risks with "frontier" market investing. Frontier is just a very nice way of saying "undeveloped and more importantly untested." For all of the development projects that Dubai undertook, what is clear is that it failed to develop a system for controlling rampant debt expansion and a real estate bubble. All of that was backed by some sort of implicit guarantee that the government would back the debt. Of course, an implicit guarantee is much different than an explicit one, as investors always find out much to their regret. 

This is a story that has been spun a hundred times over the past century when we talk about emerging-markets countries, and it will likewise be the case for the latest nascent developing economies like those in Eastern Europe, the Middle East, Africa, and up-and-coming Asian nations such as Vietnam, Indonesia, and Thailand. My point isn't that there is never a time to invest in Frontier-themed ETFs. Rather, you need to do so fully aware that these nations are historically subject to wild crashes, have governments that act in their own interest over the interests of investors, and often have illiquid securities. That means you need to keep your exposure in line with your risk tolerance in your portfolio and be ready to take some lumps along the way. 

Before everyone starts going off about how the United States is guilty of these exact same issues, I recognize the irony. Saying that the U.S. behaved like an emerging-markets country during the credit bubble is unfortunately not a new insight. The difference is, even with all of the lost manufacturing jobs over the years, we are still the world's largest manufacturer by total dollars, so we at least have something to fall back on.   

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