A Least-Bad Option for Foreign Developed Equity Exposure

While we usually recommend using single-country funds as satellite holdings given their niche exposure, we think iShares MSCI United Kingdom Index EWU is suitable as a core foreign-equity holding.

First of all, this fund is dominated by high-quality global firms such as VodafoneVOD, British American Tobacco BTI, HSBC HBC, and GlaxoSmithKline GSK. In fact, large-cap U.K. equities (in pound sterling) are actually less volatile than large-cap U.S. equities. Second, over the past 15 years, EWU has provided slightly better diversification benefits relative to the broader MSCI EAFE Index (which includes developed Europe and Asia), perhaps because the U.K. equity market tends to be more defensive, with heavier weightings in energy, consumer staples, and telecoms, relative to the S&P 500. We also note that this fund has been less volatile than the MSCI EAFE Index.

Before adding this fund, we suggest investors check their existing exposure to U.K. equities. On average, U.K. equities account for about 20% of a broad foreign-developed fund and about one third of a Europe fund.

Fundamentals
As of the end of April 2012, this exchange-traded fund was trading at a relatively low trailing 12-month P/E of 10 times (10 years ago, this ratio was 24 times), which reflects pessimism regarding a weak U.K. economy, slowing global growth, uncertainty regarding the eurozone, and the long-term effects of deleveraging across the developed world. While these macroeconomic issues may continue to weigh on U.K. equities in the near and medium term, we think U.K. equities may be one of the "least bad" options within the international developed equities space, as Europe grapples with its sovereign debt crisis and as Japanese exporters continue to struggle against a strong yen. And fundamentally, corporate United Kingdom is in good shape, with healthy balance sheets, solid margins, and rising dividends. At this time, this fund's dividend yield is over 3%. While we think this ETF looks attractive for investors with a long term horizon, we do expect this fund to see some volatility in the near term given the ongoing euro debt crisis.

Like most international-equity ETFs, EWU does not hedge its foreign-currency exposure. As such, its returns reflect both asset price changes and changes in the U.S. dollar and pound sterling exchange rates. Some investors seek non-U.S.-denominated assets as a hedge against a potentially weakening U.S. dollar. At this time, the pound sterling is trading about 20% below its historical average against the euro and is trading slightly below average against the U.S. dollar, which reflects expectations that the Bank of England will maintain record-low rates in 2012 and may extend its bond purchase program. We don't expect to see any strong downward movements in the pound sterling versus the U.S. dollar in the near term.

This fund is diversified and holds many firms that boast solid competitive advantages or economic moats. In addition, many large-cap U.K. firms, such as HSBC and Vodafone, have strong and well-established operations in the faster-growing emerging markets. GlaxoSmithKline GSK and AstraZeneca AZN, which carry wide moat ratings, are able to maintain their competitive advantages with their portfolios of patented drugs and their robust research-and-development budgets to support new drug discoveries. While other top holdings such as BP BP, Royal Dutch Shell RDS.A, BHP Billiton BHP, and Rio Tinto RIO operate in the volatile commodities industry, each of these firms has a narrow moat, thanks to their global collection of hard-to-replicate reserves.

Portfolio Construction
This fund tracks the MSCI United Kingdom Index, which is a capitalization-weighted index that aims to capture 85% of the total U.K. equity market. EWU holds about 105 stocks that trade on the London Stock Exchange. The fund is top-heavy, with the top 10 stocks comprising 46% of the portfolio. Many of this fund's top holdings are also listed in New York and are covered by Morningstar equity analysts.

Fees
The U.K. market is very liquid, so we think EWU's expense ratio of 0.53% is a bit on the high side. However, there are currently no other options for broad exposure to U.K. equities. This ETF has done a good job tracking its index.

Alternatives
For somewhat similar exposure, investors can consider European ETFs. We suggest Vanguard MSCI Europe ETF VGK, which charges a low fee of 0.14%. Those looking for exposure to only eurozone countries can consider iShares MSCI EMU Index EZU, which charges 0.52%.