Country exchange-traded funds (ETFs) have become tremendously popular with investors because they embody the many advantages of this versatile asset class, such as a wide range of choices, ample liquidity, and low expenses. But the plethora of country ETFs now available makes it more difficult for investors to identify the ones that will make the best investments. Here are our Top 10 factors to consider when buying a country ETF that is the most appropriate for your portfolio.
Top 10 factors to consider for a country ETF
- Country Risk: This should be the starting point for selecting a country ETF. Country risk is a catch-all phrase for risk associated with investing in a foreign nation, including political risk, economic risk, currency risk, and sovereign risk. A change in any of these risks can have a substantial effect on the overall risk of investing in a nation. For example, an elected government may be overthrown by the army (political risk), or a country’s high debt levels may make debt servicing doubtful (sovereign risk), or massive capital outflows may imperil growth (economic risk). Currency risk is another important risk that should be assessed, as most ETFs do not hedge it either because of the prohibitive cost of hedging in emerging markets or the non-availability of hedging instruments. With ETFs now available even on smaller economies such as Colombia, Peru, and Qatar, country risk assumes greater importance when selecting an ETF.
- Underlying Index: Another key factor to consider is the index on which the ETF is based. It is usually preferable to invest in an ETF that is based on a broad, widely followed index rather than a narrow and/or relatively obscure index. As an example, two China ETFs currently available are the iShares MSCI China Index Fund and the Global X China Consumer ETF. The former tracks the MSCI China index – a broad and well-known index – while the latter tracks the Solactive China Consumer index. While the iShares MSCI ETF may be appropriate for most investors who are looking to add China exposure to their portfolios, the Global X ETF may only be suitable for experienced investors who desire specific exposure to the Chinese consumer market.
- Valuations: As with stock investments, valuations are of paramount importance when investing in ETFs. In ETF investing, valuations refer to those of the underlying index. As an example, consider the relative valuations of the BRIC behemoths. On May 22, 2014, Brazil’s Bovespa index was trading at a P/E of 16.2 and had a dividend yield of 4.2%; Russia’s RTS dollar index had a P/E of 6.4 and a dividend yield of 3.5%; India’s Sensex-30 index had a P/E of 18.1 and a dividend yield of 1.4%; and China’s Shanghai Composite had a price-earnings ratio (P/E) of 9.9 and a dividend yield of 3.0%. India’s premium valuations at that point were based on optimism that it would be the first BRIC nation to rebound after a new pro-business government won general elections, while Russia was trading at discount multiples due to tensions with Ukraine. A value investor would probably find valuations for Russia and China more attractive than those for Brazil and India.
- Long-Term Prospects: Investing in a country ETF requires some understanding of the underlying nation’s long-term economic prospects. As an example, the investing thesis for the aforementioned BRIC nations is an intuitively easy one to understand, since these economies will inevitably be among the world’s largest in the not-too-distant future (China is already the second-largest economy). It is much more difficult to make a compelling investment case for a small emerging economy that carries its own set of risks. So unless you have a unique insight into some far-flung economy by virtue of having lived or worked there, it might be best to stay with the larger nations, as visibility on their long-term prospects is much better.
- Expense Ratios: Expense ratios for country ETFs are much lower than for closed-end country funds, but are significantly higher than for domestic ETFs. Given two somewhat identical single-country ETFs, it may be preferable to opt for the one with the lower expense ratio, since a reduction of even 0.25% can make a difference over a long period of time.
- Tracking Error: Make sure you check the tracking error for a country ETF before you invest in it. While a small tracking error means that the ETF tracks the index closely, a larger tracking error may erode part of your ETF returns over the long term. For instance, assume the return on an equity index is 10% annually over a 10-year period and the annual return on an underlying ETF - due to tracking error of 0.5% - is 9.5%. On an initial USD 50,000 investment, that 0.5% tracking error will result in a shortfall of USD 5,775 or about 4.5% after 10 years (i.e. USD 129,687 - USD 123,911).
- Total Assets: An ETF’s total assets are another important factor to be considered when making an investment decision. An ETF with assets below USD 100 million may have limited investor interest, which will lead to constrained liquidity and wide trading spreads.
- Trading Volumes: This follows from the previous point, as a larger ETF will generally have higher trading volumes than a small ETF. As with a stock, higher trading volumes translate to better liquidity and tighter spreads. For example, the iShares MSCI China Index Fund mentioned earlier had total assets of USD 913 million and trading volume of 491,000 shares as of May 23, 2014, while the Global X China Consumer ETF had assets of USD 142 million and trading volume of 75,000 shares.
- Risk Tolerance: This factor pertains to the investor rather than to the ETF. Diversification and the quest for higher returns are investment objectives that are common to most ETF investors, but risk tolerance differs widely from one investor to the next. While an ETF may look attractive on the basis of its expected return, it may be prudent to check its risk metrics before committing capital. One such measure of risk is the ETF’s 30-day volatility. As of May 22, 2014, volatility for the BRIC markets was as follows – Shanghai Composite 13.3%, Sensex-30 15.1%, Bovespa 18.5%, and RTS dollar 27.4%. Contrast these volatility levels with that of the S&P 500 (9.1%) and TSX Composite (7.7%). With emerging markets two to three times as volatile as North American markets, ensure that you can handle this level of volatility before buying a country ETF. (See also "Buying on Margin for ETF investors.")
- Timing: As with life, timing is everything when it comes to country ETF investing. Consider the sizzling performance of India-based ETFs from August 2013 to May 2014. The two main Indian equity benchmarks – the Sensex-30 and the CNX Nifty index of 50 companies – reached a multi-year bottom on August 28, 2013 on elevated concerns about India’s continued ability to attract foreign capital to fund its budget and trade deficits. As the pro-business Bharatiya Janata Party gained momentum in the run-up to the May 2014 elections, investors overlooked its right-wing leanings and piled into Indian equities. The two indices reached record highs on May 16, 2014, for average gains of about 47% from their lows. The four biggest India ETFs in the U.S. reached record highs on May 22, 2014, having surged by an average of 63% from their August 2013 lows. Investors who bought these ETFs in 2013 were rewarded handsomely for their willingness to assume more risk in this particular instance.
Buying country ETFs
Once you have identified the country ETF in which you want to invest, buying it is easy. Since most ETFs trade on major exchanges, buying an ETF is just like investing in a stock. You can either invest in an ETF through an online discount brokerage, or through your investment advisor. Just as you would with stock orders, pay attention to the ETF’s liquidity and look for small bid-ask spreads.
As mentioned earlier, although small single-country ETFs should generally be avoided because of the higher degree of risk involved, one way to diminish this risk is by investing in a regional ETF that has the country as a component. Regardless of whether you are investing in a single-country ETF or a basket such as a BRIC ETF, our Top 10 factors may help you to select the country ETFs that are best suited to your investment objectives and risk tolerance.
Disclosure: The author did not own any of the securities mentioned in this article at the time of publication.