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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.

Patricia Oey is an ETF analyst at Morningstar.

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