The iShares MSCI Hong Kong Fund (NYSEARCA: EWH) seeks to track the performance of the MSCI Hong Kong Index, which is composed of equities traded on the Hong Kong Stock Exchange. EWH's benchmark index includes various large-, mid- and small-cap firms that operate predominantly in mainland China and Hong Kong. The fund employs an indexing investment approach and does not take advantage of significant changes in market prices of its underlying holdings. Since its inception in 1996, the fund has generated an average annual return of 5.8%.

EWH and its benchmark index have a heavy weighting on China's and Hong Kong's financials sectors. Other industries in the fund's portfolio include utilities, consumer services, consumer durables and transportation. The fund's holdings are traded in Hong Kong dollars, and EWH does not hedge its foreign currency exposure.

How It Tracks It

As of August 2015, the fund holds 40 stocks traded on the Hong Kong Stock Exchange and has $2.9 billion in net assets. Because Hong Kong is considered a financial powerhouse of Asia with numerous financial companies domiciled there, the fund's portfolio is highly concentrated in the financials sector. EWH has holdings in real estate at 28% allocation; insurance at 18% allocation; banks at 8% allocation; and diversified financials at 8% allocation. Since Hong Kong is a small autonomous territory of the People's Republic of China, many companies within the fund's portfolio cater to the Chinese consumer market as well as other Asian countries adjacent to Hong Kong.

The fund's top five holdings account for 46.5% of EWH's assets and include companies such as AIA Group, CK Hutchinson Holdings, Hong Kong Exchange and Clearing, Sun Hung Kai Properties and Cheung Kong Property Holdings. The fund's holdings have a somewhat low diversification as AIA Group, the largest pan-Asian life insurance group, has 18% allocation. The top 10 holdings account for 65% of EWH's invested assets.

The fund's tracking error since inception has been under 0.5% thanks to the superior representative sampling strategy used by EWH. The tracking error still arises due to slight differences between the fund's holdings and its benchmark index, as well as transaction costs incurred by the fund and various expenses it charges investors to operate its business.

Management

EWH was established on March 12, 1996, and has been under the management of BlackRock Fund Advisors, a subsidiary of BlackRock, Inc., a well-known and established investment management company with over $4.5 trillion of assets under management (AUM). BlackRock Fund Advisors, formerly Barclays Global Fund Advisors, manages hundreds of various iShares ETFs, which have a high reputation among investors. EWH belongs to the group of global/international stock ETFs that track various foreign indexes.

Characteristics

The fund uses representative sampling by holding all stocks in the benchmark index and rebalancing its portfolio from time to time to mirror the performance of the underlying index. Because EWH holds many companies from the financials sector with stable dividend policies, it has an above-average dividend yield of 2.2%. The fund's portfolio turnover of 6% is very low when compared to an average turnover of 28% for its peers. EWH has an annual expense ratio of 0.48%, which is much lower than an average ratio of 0.68% for ETFs with similar holdings. EWH is traded on the New Stock Exchange Arca and investors can purchase the fund's shares through numerous investment brokers.

Suitability and Recommendations

Even though many companies in EWH's portfolio are domiciled and traded in Hong Kong, all of them have strong ties to the Chinese economy, which showed troubling signs of slowdown in 2014-2015. As a result, the fund's returns declined significantly April through August of 2015 and may continue sliding as fears persist that China's economic performance may continue diving further. Because the Chinese government keeps very tight control over statistical data, recent economic figures released may not fully reflect the extent of economic slowdown in China and investors should take official numbers with a grain of salt.

In August 2015, Chinese currency showed increasing signs of weakness and consequently devalued as a result of large foreign capital outflows from the Chinese stock market, which declined by over 30% over the previous two months. Because Hong Kong's economy is closely tied to the performance of the Chinese economy, the Hong Kong dollar may see increasing depreciation pressure regardless of its peg to the U.S. dollar. If China continues weakening its currency, the fund's returns may be substantially lower when translated into U.S. dollars. Investors should be mindful about currency risk associated with investing in EWH.

EWH's holdings greatly benefited from the real estate boom in China, as real estate investment and prices in China soared. However, due to recent weakness in the real estate market in China, real estate companies of the fund demonstrated significant declines. As Chinese authorities continue lowering interest rates and injecting liquidity into the economy, the real estate market may benefit from these measures.

Due to the spillover or downturn of the Chinese stock market, the fund showed increasing volatility and significant decline in its returns. Its five-year standard deviation of 18% is significantly higher than 11.7% on the S&;P 500 Index. With the five-year return of 10.1%, EWH's five-year Sharpe ratio is 0.62, which is half of that for the S&;P 500 Index. As worries about the Chinese economy continue persisting, investors should expect even higher volatility in the fund's returns.

According to modern portfolio theory (MPT), EWH is most appropriate for investors interested in growth investment strategy, as Chinese and other Asian emerging markets are likely to continue demonstrating high economic growth in the future.

EWH is most appropriate for investors who are interested in gaining exposure to stocks traded on the Hong Kong Stock Exchange who operate their businesses predominantly in Asian emerging market countries. Because the fund is exposed to stocks traded at one particular jurisdiction, EWH should be included as a part of the well-diversified portfolio.

How Financial Adviser Clients Could Use This ETF

Despite an economic slowdown, China remains one of the fastest-growing economies in the world. For this reason, financial advisers can recommend EWH to clients who are looking to take advantage of these high economic prospects but do not mind being exposed to currency risk and high volatility of returns.

As the real estate market in China continues weakening, this poses the big risks to the fund's performance. Financial advisers should caution their clients against allocating a large proportion of their portfolios to EWH. Because 18% of the fund's portfolio is allocated to AIA Group, financial advisers should do thorough research of this well-known insurance group to gauge its returns prospects before recommending this fund to clients.

Main Competitors and Alternatives

There are very few alternatives to EWH that have portfolios dedicated to investing in Hong Kong equities. One option for investors to consider is the iShares MSCI Pacific ex-Japan fund, which invests in Pacific countries, including Australia at 59% and Hong Kong at 27%. Like EWH, this fund is heavily weighted toward the financials sector at 55%, and it has an expense ratio of 0.49%.

The iShares MSCI Asia ex-Japan Index fund is another alternative since this ETF has a small holding of Hong Kong equities, about an 8% allocation. It is more tilted toward bigger Asian countries, such as China at 34%; South Korea at 17%; and Taiwan at 14%. The fund has more diversified holdings compared to EWH, with no sector accounting for more than 35%. Its expense ratio is 0.68%.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.