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South Korean Government Moves to Boost Economy--and Stock Market

Here's an ETF that can manage exposure to this country's equity market. 

Patricia Oey, 09/12/2014

The South Korean stock market has been a relative underperformer this year, partly because of weak economic growth and sluggish domestic spending. To address these issues, finance minister Choi Kyung-hwan earlier this summer announced a USD 40 billion stimulus package, and in August, the Bank of Korea cut the country's key interest rate for the first time in 15 months. Of greater interest to investors is a proposal that would push corporate South Korea to boost dividends. Choi has proposed tax incentives for dividend increases and tax penalties for retained earnings not used after three years. These measures are currently awaiting parliamentary approval. The combination of these efforts could help spur the performance of the South Korean equity market in the near term.

Currently, the dividend yield of the South Korean equity market is the lowest in the region at only 1.1%. This compares with yields of 2.9% in Taiwan, 3.9% in Hong Kong, and 3.2% in China. This is despite the fact that the listed units of Korea's top 10 conglomerates held USD 430 billion in cash reserves at the end of last year, up 11.3% from the previous year, according to financial information provider FnGuide.

Historically, South Korean equities tend to trade at a lower price/earnings ratio than the MSCI Emerging Markets Index, and this "Korean discount" is usually attributed to corporate governance issues. Many of South Korea's large-cap firms are part of family-run conglomerates called chaebols. These firms often have a legacy of maintaining complicated cross-holdings, supporting unprofitable subsidiaries, and engaging in murky related-party transactions. The Korea discount is also due to the fact that chaebols typically maintain large cash balances and pay out relatively lower dividends. If Choi's tax proposals to promote dividend payments are implemented, this may help alleviate South Korea's valuation discount.

There are currently a handful of South Korea-focused funds available to investors.   iShares MSCI South Korea Capped EWY is by far the largest fund, at $4.7 billion.

Suitability
IShares MSCI South Korea Capped provides market-capitalization-weighted exposure to the South Korean equity market, which has a cyclical orientation, given its heavy exposure to technology, consumer discretionary, and industrial firms, many of which are large exporters.

Because of this cyclical tilt, South Korean equities are fairly volatile. This fund's trailing five-year standard deviation of returns of 23% is higher than those experienced by the comparable cap-weighted indexes measuring stock market performance in places such as Taiwan and Hong Kong. This fund's index's annualized trailing three-year beta versus the S&P 500 is also high, at 1.3. EWY is also very concentrated--top holding Samsung Electronics accounts for around 20% of fund assets, and the top 10 holdings collectively account for about 50%.

As a single-country fund, EWY is suitable as a satellite holding. Investors can use this fund to manage their exposure to the South Korean equity market. Currently, both FTSE and S&P classify South Korea as a developed market, whereas MSCI categorizes it as an emerging market. For investors using a cap-weighted index fund for their emerging-markets stock allocation, their exposure to South Korean stocks will depend on which benchmark their fund tracks. Investors should check their exposure to South Korean equities before investing in this fund.

Fundamental View
Large-cap South Korean firms have demonstrated their might during the past decade. Many companies, such as Samsung Electronics, Hyundai, and LG, have successfully moved up the value chain and have increased market share. They now have well-established, globally recognized brand names. In the coming years, South Korean corporations are expected to benefit from free-trade agreements with the European Union and the United States, which were signed in 2011. South Korea also has strong economic ties to China--exports to China account for a fourth of its total exports. Economic development in China, as well as in other emerging markets, should be an important driver of growth for many of South Korea's larger companies in the medium term.

When considering this fund, investors should evaluate the outlook for Samsung Electronics, EWY's largest holding. Samsung currently holds the number-one position in the global smartphone market, and mobile telephony accounts for about 60% of the firm's operating profit. Samsung is starting to see its mobile-phone sales mix tilt away from higher-margin smartphones toward lower-margin mid- to lower-end phones, driven by strong demand for lower-end phones in emerging markets and slowing global growth for high-end phones. However, as the time of this writing, downside for this stock might be limited. Current low valuations reflect the more challenging near-term outlook. In addition, investors have been pressuring Samsung to return some of its $50 billion-plus cash pile to shareholders. Samsung's shares currently sport a dividend yield of about 1%, which is still below Apple's AAPL 2%. Any improvements in payout ratios will be positive for the stock.

As for EWY's other holdings, the exporters among them are seeing competitive pressures ebb. In 2013, South Korean electronics, machinery, and automaking firms had to deal with a tough competitive environment as Japanese peers benefited from a rapidly declining yen. So far this year, the yen has stabilized, and a healthier outlook in the U.S. and Europe should also benefit South Korean exporters. However, on the domestic-demand front, Korean consumers have the highest levels of consumer debt among OECD nations, and property prices have been softening. These issues are having a negative impact on consumer sentiment and spending.

Index provider MSCI had South Korea under review for reclassification from emerging- to developed-market status for a number of years. South Korea meets MSCI's requirements for developed-market status relating to economic development, as well as capital market size and liquidity. However, in its 2014 Annual Market Classification Review, which was announced in June 2014, MSCI stated that it had removed South Korea from its review list, citing a lack of significant improvements regarding accessibility by foreign investors. While South Korea was under review, there was some uncertainty regarding a potential reclassification, which would likely result in some short-term volatility in share prices and local currency as foreign investors rebalanced their portfolios. Now that South Korea is no longer under review, this uncertainty is no longer an issue.

Portfolio Construction
This fund tracks a float-adjusted, cap-weighted index that aims to capture 85% of the publicly available market cap of South Korean stocks. On Feb. 11, 2013, this exchange-traded fund changed its index from the MSCI Korea Index to the MSCI Korea 25/50 Index. MSCI's 25/50 indexes are designed to take into account U.S. IRS investment constraints needed for a fund to qualify as a Regulated Investment Company. This change was necessary as Samsung Electronics' allocation within EWY continues to edge closer to 25%, thanks to its recent outperformance. To be RIC compliant, funds cannot have any holdings that exceed 25% of assets, and the sum of all issuers whose weighting is above 5% cannot exceed 50%. If the fund had not changed its index, it could have incurred tracking error if these IRS-mandated thresholds were breached. This fund does not hedge its foreign-currency exposure.

Alternatives
An actively managed open-end option is Matthews Korea Investor MAKOX. Relative to EWY, this fund has less exposure to the global cyclical sector such as industrials and technology and has an overweighting in consumer names. While it has more of a mid-cap tilt, Matthews Korea Investor has generated better risk-adjusted returns over the trailing five and 10 years, relative to EWY. This fund would be more suitable for investors looking for exposure to domestic growth trends, whereas EWY would be better for those looking for a fund to play a global recovery. Matthews Korea Investor charges 1.13%. EWY's expense ratio is 0.61%.

Two other options are actively managed Korea Fund KF (expense ratio 1.13%) and Korea Equity Fund KEF (expense ratio 1.57%), both of which are closed-end funds.

 

Disclosure: Morningstar, Inc.’s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index. 

Patricia Oey is an ETF analyst at Morningstar.

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