How to Tap South Korea’s Growing Economy

South Korea is the fourth-largest economy in Asia and, along with some of its regional neighbors, is recovering quickly from the 2008 global economic downturn. In our opinion, South Korea has some attractive growth opportunities in the near and medium term. With its strong export orientation (exports account for about 60% of GDP) and heavy weightings in cyclical industries such as information technology, industrials, financials, and materials, the South Korea market is well positioned to benefit from a global economic recovery. South Korea also has strong economic ties to China--exports to China account for about 15% of South Korea's GDP. Economic development in China will be an important driver of growth for many of South Korea's larger companies.

 IShares MSCI South Korea Index (EWY) is currently the only ETF that provides broad exposure to the South Korea equity markets. We view an investment in this fund as a satellite holding--as a point of reference, within a broad international fund (which excludes the United States), South Korea accounts for about 2% to 3% of the total portfolio. EWY tracks the MSCI South Korea Index and holds about 100 stocks. Investors should note that EWY has a slight large-cap tilt relative to the frequently cited Korea Composite Stock Price Index, or KOSPI, which includes more than 700 stocks. Through most of 2009, EWY has significantly outperformed the KOSPI.

Despite EWY's heavy 28% weighting in information technology, the fund's correlation to  PowerShares QQQ  was not very strong at 0.81, and was lower in 2007 and 2006 at 0.75 and 0.53, respectively. EWY also does not have a strong correlation with other major U.S. indexes, and therefore would serve as a good diversification tool, especially for investors with insufficient exposure to international markets.

It is important to note that South Korea is considered a developed market by index provider FTSE Group. While MSCI Barra, whose indexes are more widely followed in the U.S., still classifies South Korea as an emerging market, the country is currently under review for potential reclassification to a developed market in 2010. We suggest that investors interested in the South Korea markets check their international holdings to ensure they are not unintentionally overweight or underweight South Korea.

When evaluating EWY, it is important to consider the outlook for Samsung Electronics, which accounts for almost 20% of the total portfolio. It is a global leader in the manufacturing of consumer electronics, cell phones, memory chips, and LCD panels. While Samsung's leading market shares, economies of scale, and advanced manufacturing capabilities in memory chips and LCD panels provide the company with some competitive advantages, these two industries are notoriously cyclical and fiercely competitive. EWY has even more exposure to the memory chip and LCD panel industry through its holdings in Hynix Semiconductor and  LG Display (LPL), each of which accounts for around 2% of the portfolio. At this time, recovering demand for consumer electronics is expected to drive improving profitability in these industries in the near term, but the profitability outlook can change fast, depending on how quickly new capacity can be built, and how long healthy demand can last. EWY's second largest holding, at around 7%, is steel manufacturer  POSCO (PKX). With modern production facilities and one of the lowest cash production costs in the industry, POSCO is well positioned to benefit from growing steel demand from its emerging-markets neighbors, particularly China.

Turning to major sector holdings, industrials is the second-largest weighting in EWY after information technology, and this sector includes shipbuilders (South Korea is the world's largest manufacturer of ships) and heavy engineering and construction firms, some of which have contracts for large oil and gas projects in the Middle East and Asia. Financials is the third-largest weighting, and current trends in the Korean financial-services industry include deregulation, which is expected to drive some consolidation, and a recovering domestic economy, which is expected to drive earnings growth.

At this time, EWY is trading at a trailing 12-month P/E ratio of around 15 times, which is near highs achieved in 2007 and in line with regional Asian funds. However, we expect a recovering global economy, and increased exposure to economic growth in China will help drive profitability for South Korean firms in the near and medium term.

Portfolio Construction
This passively managed fund tracks the MSCI South Korea Index, which is a capitalization-weighted index that aims to capture 85% of the publicly available total market capitalization. Component companies are adjusted for available float. The MSCI South Korea Index is tech heavy, with information technology accounting for 28% of the index. The next-largest sectors by weight include industrials, financials, materials, and consumer discretionary, which account for 17%, 16%, 13%, and 11%, respectively. The other five sectors each weigh in at 6% or less of the index.

The two largest holdings in this fund are significant. Samsung Electronics, which accounts for 17% of the portfolio, is a global leader in semiconductor, telecommunication, digital media, and digital convergence technologies. POSCO, which accounts for 7% of the fund, is the world's fourth-largest steel producer. Our steel analysts believe POSCO has a narrow moat, thanks to its low-cost production process and technology leadership. Overall, EWY is cyclical in nature, given its heavy exposure to manufacturing and heavy industry.

Fees
International ETFs tend to have higher expenses, relative to domestic ETFs. However EWY's expense ratio of 0.63% is a little on the high side, perhaps due to the lack of competition.

Alternatives
At this time, EWY is the only South Korea-specific ETF. Regional ETFs with relatively heavy South Korea exposure include iShares S&P Asia 50 Index (AIA) and iShares MSCI Asia ex-Japan Index (AAXJ). The South Korea weighting in each of these funds is 22% and 17%, respectively.

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Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.