Trading Tactics Matter with International ETFs

For most investors, we recommend a 20% to 25% allocation in foreign equities, given their diversification benefits within a portfolio. Investing in foreign equities provides a hedge against a weakening United States dollar and allows for exposure to faster-growing economies. Passively managed ETFs that aim to cover a broad regional or country index are an easy way to invest in macroeconomic themes. Investors have enthusiastically embraced this asset class in 2009. For the year to date through October, net inflows into international stock ETFs reached almost $23 billion, accounting for almost 36% of total net flows into ETFs.

When investing abroad, obvious issues to consider include a country or region's outlook for GDP growth and the macroeconomic environment. And, before purchasing an ETF, investors should examine the ETF's holdings and sector weightings. Unlike in the U.S., where a broad market fund such as  SPDRs (SPY) provides a fairly diversified exposure to the U.S. economy, many international ETFs can have significant sector concentration. For example, the Australia ETF  iShares MSCI Australia Index (EWA) has a 30% weighting in export-focused materials and energy companies, which includes  BHP Billiton (BHP),  Rio Tinto , and Woodside Petroleum (WOPEY). Global demand for commodity products, particularly from China, will be a more significant growth driver for these firms, rather than domestic consumption. As such, this fund is not only a play on Australia but is also an indirect play on commodity prices. Investors can check Morningstar's ETF reports for information about an ETF's holdings and how that ETF fits into a portfolio.

As for trading strategies, general ETF trading tactics apply. Use limit orders, especially for large orders in not-very-liquid funds, otherwise your execution price within your market order could vary, and sometimes significantly. In addition, not only do some ETFs have low trading volume, some ETFs' underlying holdings are also not very liquid. This can result in higher bid-ask spreads. (Investors can check real time bid ask spreads by entering an ETF's ticker at the top of the Morningstar.com homepage.) Bid-ask spreads can also widen on volatile trading days--we suggest investors monitor an ETF's bid-ask spread over a few days to determine what the average bid-ask spread, excluding general market volatility, should look like for a particular fund, and invest on days when there is lower market volatility.

We also recommend that when possible, investors should trade an ETF when its underlying holdings are trading. The U.S. market overlaps most of the day with Canadian and Latin American markets, and it overlaps in the morning for European markets. And some international funds invest only in ADRs, which trade in New York, such as  PowerShares Golden Dragon Halter USX China (PGJ). When an ETF and its holdings are trading at the same time, investors can check the ETF's intraday indicative value, which is an estimate of the underlying value of the securities and cash that make up the ETF and is quoted every 15 seconds by the exchange listing the ETF. In other words, the fund's IIV is like a constantly updated NAV. (NAVs are calculated only once at the end of the New York trading day.) Investors can check an ETF's IIV on Google Finance by entering the fund's ticker plus a suffix, which is usually ".iv" (for example, for  iShares Emerging Markets Index (EEM), the ticker would be EEM.IV). If that does not work, the fund's Web site should have the correct ticker. By noting a fund's price relative to its IIV and comparing that with its historical price to NAV premium/discount (which can be found on Morningstar.com), investors can get an idea of how the fund usually trades relative to its NAV and how to price their limit order.

For funds that focus on the Asian region and hold securities that trade when the U.S. market is closed, their IIV generally does not move during the U.S. trading day. In this case, the IIV is based on stale prices, whereas the ETF price reflects news and information since the close of the Asian markets. Some would argue the ETF price is a more accurate estimate of the value of the fund, relative to the IIV. We point out that information flow is 24 hours a day. While the ETF incorporates information during the New York trading hours, the ETF's underlying holdings are incorporating information when it trades on its local exchange. Therefore, there is always going to be a difference in returns between the ETF (which trades in New York) and its NAV (which is based on underlying holdings that trade on a local exchange). As such, we think it is difficult to boost returns by playing the variance in the premium and discount.

Brazil ETFs such as  iShares MSCI Brazil Index (EWZ) and  Market Vectors Brazil Small-Cap ETF (BRF) have been trading at a relatively high premium to both their NAV and IIV over the past few weeks. In late October 2009, the Brazilian government implemented a 2% tax on capital entering the country to invest in equities and fixed-income instruments, in an effort to slow the appreciation of the Brazilian real, which has gained more than 30% against the U.S. dollar this year. This new tax does not affect investors already holding Brazilian ETFs. But while the fund sponsors of EWZ and BRF do not plan to raise their expense ratios to incorporate this new tax, new investors are partially paying the tax through higher premiums to NAV. According to Van Eck, which runs the Market Vectors ETF, before the announcement of the 2% tax, BRF used to trade at around a 60 basis point premium to its NAV. Now it trades at about a 190 basis point premium to NAV, due to ongoing steady net inflows into the fund. As for EWZ, in the third quarter (before the tax was implemented), EWZ traded within -0.5% to 0.5% of its NAV value for 92% of the time. Over the past four weeks, EWZ traded at an average 0.52% to its NAV. EWZ's lower premium relative to BRF is due to EWZ's greater liquidity, as well as the higher liquidity of EWZ's holdings. We expect the premium on these funds to remain as long as the funds continue to see net inflows. If the funds were to start to see net outflows, we would expect the premium to decline.

Finally, we want to highlight the issue of foreign exchange rates. Foreign currencies such as the British pound and the Canadian dollar have each appreciated about 15% for the year to date, versus the U.S. dollar. These strengthening currencies have supported strong performance of funds such as  iShares MSCI United Kingdom Index (EWU) and iShares MSCI Canada Index (EWC), which have returned 40% and 50%, and respectively. The S&P 500, on the other hand, has returned about 22% over the same time period. The U.S. Federal Reserve's plan to maintain low interest rates will continue to weigh on the dollar in the near term. However, in the medium term, the dollar could start to stabilize versus other currencies. According to Robert Johnson, our equity research associate director of economic analysis, the U.S. dollar is starting to appear 'undervalued when considering the prices of similar goods in different countries'. A recovering U.S. dollar exchange rate will be a drag on the performance of foreign ETFs. We think the strong currency lift to certain foreign ETF performance in 2009 will be hard to repeat in the near term.

 

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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.