What to Watch For When Investing in International ETFs

For investing internationally, single-country and regional ETFs are practical tools for achieving very specific exposure. Nearly every developed and emerging-markets country has at least one ETF tracking it, and there are ETFs for regional Latin American, Europe, and Asia areas.

In this article, we will highlight some of the issues specific to investing in international ETFs. We'll also discuss investing during a crisis by taking a closer look at the performance of the Egypt ETF during and after a two-month stock market shutdown, and the performance of Japan ETFs after the earthquake and tsunami.

ETFs that track securities listed on overseas exchanges tend to trade at greater premiums and discounts to their net asset values (NAVs), which is usually a static value as most international markets are closed during some or most of our trading day in the U.S. This is not necessarily a bad thing, as ETFs, while trading, will reflect new news, and changing investor sentiment toward the asset class. In other words, international ETFs are essentially price discovery vehicles. We can also check the bid-ask spreads--typically, if the bid and ask prices maintain a spread of just a few pennies from each other, the market is showing general agreement on the true value of the ETF and its underlying securities. A tight bid-ask spread is probably a better indicator that an ETF is trading in-line with the value of its portfolio, as opposed to comparing an ETF's price with its static NAV. 

For trading international ETFs, we recommend that investors check a fund's historical premium and discount to NAV trend (here is an example of where you can find this data on Morningstar.com ETF data reports) and compare that to the premium or discount of its current price versus its NAV. Generally speaking, we would expect most international ETFs to trade at both a discount and a premium over time, and on average, to trade at an annual premium or discount of less than 50 basis points. Investors can check an ETF's NAV on Morningstar.com by entering the fund's ticker plus the suffix ".nv" into the security search box. We recommend buying or selling an ETF when it is trading within a normal range away from its NAV, and using limit orders.

Some ETFs consistently trade at a premium to their NAVs. For example,  Market Vectors Egypt  traded at an average monthly premium to its NAV 11 out of 12 months in 2010, for an annual average premium of 1.1%. ETFs that consistently trade at a premium to their NAV usually invest in hard-to-access asset classes, like Egypt equities. This logic was pushed to the extreme when the Egypt stock market closed from Jan. 27 to March 22, which resulted in EGPT trading at a giant 13% to 14% premium to its NAV.

While the Egypt stock market was closed, fund sponsor Van Eck suspended creation orders of EGPT, which effectively turned EGPT into a closed-end fund. During that time, speculators bid up the price of EGPT (which was essentially the only vehicle for investors to access broad exposure to Egypt equities) on the expectation that the Egypt market would rebound strongly after falling about 20% in January. Since the Egypt market has reopened, the ETF has returned to its historical average premium and is currently trading near where it was trading on Jan. 27. Those who bought the ETF when it was trading at a premium would be down 7%-15%.

In our opinion, investing in a very small and developing market such as Egypt (which accounts for less than 1% in the MSCI Emerging Markets Index) is suitable only for investors with a very high risk tolerance. However, there appears to be no shortage of interest in the ETF--at the end of 2010, EGPT had about 550,000 shares outstanding; this figure had jumped to 4.1 million by early April.

There was also a strong showing of market players looking for a bounce in Japan equities in the two weeks following the earthquake on March 11. On a few days, the two largest Japan ETFs-- iShares MSCI Japan (EWJ) and  WisdomTree Japan Hedged Equity (DXJ)--traded in heavy volume in the opposite direction of the index's overnight performance, and as a result, traded at much wider premiums and discounts. Aside from those investors looking to capitalize on a market bounce, other issues driving the price of Japan ETFs during that time included the expectation that the yen would appreciate (due to capital flow into Japan to fund rebuilding efforts), and possibly a surge in demand to borrow ETF shares to short the Japan market. Most of this speculative activity has ended, and at this time, both funds are now trading back inline with historical premium and discount averages. The two funds are also trading below post-earthquake highs hit on March 21. In our opinion, investing in ETFs during unusual trading activity is best suited for more speculative investors.

Finally, we highlight that investors interested in international ETFs should always check the holdings, as some of these funds can have large weightings in certain sectors or companies, which could make the ETF riskier than a more broadly diversified fund. For example,  iShares MSCI Australia (EWA) is a broad market ETF, but it has a 30% weighting in materials and energy companies, which includes  BHP Billiton (BHP),  Rio Tinto (RIO), 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 in international ETFs should also consider the effects of foreign exchange fluctuations. Over the last two years, the strengthening Australian dollar versus the U.S. dollar has provided a significant boost to EWA's returns. In 2009 and 2010, EWA returned 74.9% and 14.0%, respectively, far outpacing the return of the MSCI Australia Index in Australian dollars, which was 36.8% and 0.5%, respectively. This type of strong currency lift will be hard to repeat.

A version of this article originally ran on Nov. 18, 2009.

		ETFInvestor Newsletter
	Let our new newsletter, Morningstar ETFInvestor, help you navigate the exciting and new world of exchange-traded funds. Each issue includes recommendations for commonsense ETF investing,		ETF spotlights, and critical data on 150 top ETFs. This one-year subscription consists of 12 monthly issues. Download a free issue today.
	$185.00 for 12 Print Issues		$175 for 12 PDF Issues

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock Asset Management, 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.