Fallacy Of International ETFs

By ETFDatabase | June 26, 2012 AAA

The expansion of the ETF industry over the last several years has been well documented; there are now more than 1,400 exchange-traded products offering exposure to a record number of asset classes and investment strategies. The granularity of the ETF lineup is perhaps most evident in the international equity corner of the market, where there are pure play ETFs for just about every major global economy (and in many cases, multiple options to choose from). Targeting stocks of a specific country can have appeal to those investors who believe they are capable of identifying markets that will outperform their peer groups or post better-than-expected GDP growth. But unfortunately, country-specific ETFs don't always necessarily deliver direct exposure to the underlying economy.

As an example, consider the iShares MSCI Switzerland Index Fund (EWL), one of two pure play ETFs that holds primarily Swiss stocks. Though EWL may seem appealing to investors looking to tap into one of the more stable economies of Europe, a closer look at EWL reveals that the performance of the Swiss economy has only a minor impact on the performance of this ETF. That's because the underlying companies, while headquartered and listed primarily in Switzerland, derive the majority of their revenues from overseas .

1. Nestle SA

Company EWL Weight % Swiss Rev.
Nestle SA 23.43% 2.15%
Novartis AG 13.46% 1.23%
Roche Holding AG 12.67% 1.19%

Nestle is one of Switzerland's largest companies, and as such makes up a significant chunk of EWL's assets. But the food and beverage giant derives much of its revenues from overseas, including developed and emerging markets.

Allocation in EWL: 23.43%

Largest Market and % Revenue: USA 25.67%

% Revenue From Switzerland: 2.15%

2. Novartis AG

Novartis, a multinational pharmaceutical company based in Basel, Switzerland, ranks as one of the world's most profitable pharmaceutical producers with drugs such as Voltaren, Femara, and Ritalin. Unsurprisingly, much of this company's revenue comes from the U.S. where the pharmaceutical industry flourishes.

Allocation in EWL: 13.46%

Largest Market and % Revenue: USA 32.82%

% Revenue From Switzerland: 1.23%

3. Roche Holding AG

Roche Holding is the holding company for Hoffmann-La Roche Ltd., a Swiss global health-care company. The company owns pharmaceutical and diagnostic centers around the world. Novartis owns a significant portion of Roche's shares making it easy to see why Roche also gains a significant portion of its profits from the U.S.

Allocation in EWL: 12.67%

Largest Market and % Revenue: USA 33.22%

% Revenue From Switzerland: 1.19%

These three companies, which combine to make up about half of EWL's assets, generate only a small fraction of their earnings from their home market of Switzerland. That means that the price of this ETF is more likely to be impacted by demand from U.S. consumers than the health of the Swiss economy. If you're drawn to this fund as a way to tap into one of Europe's more stable economies, you may be disappointed with the correlation you end up with.

EWL is a bit of an extreme example, but this same phenomenon plays out in a number of international ETFs (especially those targeting European stocks). And it should be noted that the same factors are at play in ETFs comprised of U.S. stocks; many members of the S&P 500 now rely heavily on emerging markets such as China and India for large portions of sales and growth.

This feature of international ETFs isn't necessarily reason to steer clear of these funds; they can still be very useful tools for achieving diversification and making tactical allocations. But it's important to understand the potential limitations, and plan your strategies accordingly.

Disclosure: No positions at time of writing.

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