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Investment goals, country ETFs and return variations

By Imran Ahmed dividend returns may access ETFs like the Vanguard Dividend Appreciation ETF (VIG) or iShares Dow Jones Select Divide (DVY). VIG tracks the performance of the Dividend Achievers Select Index. DVY seeks to replicate the return of the Dow Jones U.S. Select Dividend Index. The two ETFs have combined assets of over US$20 billion although VIG has a lower expense ratio of 0.18% compared to DVYs 0.40%.6 As both these ETFs invest 90% or more of their assets directly in index stocks, it is likely the tracking error of both VIG and DVY will be within acceptable limits. For an investor seeking investments in more exotic countries or regions, picking the right ETF is more difficult despite the fewer number of ETF alternatives generally available. While ETF performance data from Japan and Singapore have already demonstrated this point, consider an investor evaluating an Emerging Markets ETF investment. Is the investor buying emerging markets stocks primarily to diversify her portfolio and reduce risk? Or generate excess returns based on assumptions of higher economic growth? Or perhaps the investor has a particularly strong view on a particular developing country(s) or region? Undoubtedly, answers to these questions will determine the ETF purchased. Consequently, the returns may vary dramatically. Investors in the US$37 billion iShares MSCI Emerging Markets Index ETF (EEM) will benefit

n the early days, exchange traded funds (ETFs)1 were primarily a vehicle for obtaining exposure to popular market indices such as the Standard and Poors 500 or the Dow Jones Industrial Average. However, much has changed since the launch of the SPDR S and P 500 ETF (SPY) in January 1993. Today, the ETF world is awash with securities representing countries and regions from virtually any part of the world that has functioning stock exchanges. For example, a search of ETFs covering Japan reveals a menu of ten different ETFs.2 Competition is healthy. A diversified product menu gives investors options and reduces fees. Consider the SPYs expense ratio of 0.09% versus the fees payable for mutual funds with similar objectives. For investors, the right ETF choice is not always straight forward. Selecting the correct ETF requires an appropriate fit between an investors goals and the ETFs aims. Often, even fine distinctions such as the index used by the ETF can alter an investors ETF choice. In the case of Japan, using different ETFs can result in sharply divergent returns. At the upper end, the SPDR Russell/Nomura Small Cap Japan ETF (JSC) comes in with a three-year return of 11.1%. At the other end of the spectrum, the WisdomTree Japan Hedged Equity (DXJ) returned -1.0 or minus 1%. Institutional investors will also take into account the ETF size, US$90

million and US$420 million for JSC and DXJ respectively. Moreover, DXJ has an expense ratio which is almost ten basis points lower than JSC.3 Singapores example also illustrates the variable nature of ETFs more clearly. The iShares MSCI Singapore Index ETF (EWS), the only Singapore country specific ETF currently available, delivered an absolute return (adjusted) of almost 116% (US$ terms) during the last three years.4 In the same period Singapores foremost stock index, the FTSE Straits Times Index delivered a total US$ return of almost 87%.5 Undoubtedly, in the case of Singapore, a stock investor would have benefitted by investing in the ETF relative to directly purchasing the domestic index. For ETF investors not all stories have happy endings like the EWS Singapore experience. So what are a few of the key factors to consider when using ETFs to invest in a particular country or region? For starters, one must have a well defined goal for investing in a country / region. The investment objective lies at the heart of determining the optimal ETF solution. An investor buying an ETF in the US market has many alternatives. Depending on her aim, the investor can simply purchase ETFs which track the performance of mainstream indices like the Standard and Poors 500 (SPY ), Dow Jones Industrial Average (DIA) or the NASDAQ 100 (QQQ). Investors desirous of some income through superior

Japan ETF Performance Data

Fund Name SPDR Russell/Nomura Small Cap Japan iShares MSCI Japan Small Cap Index WisdomTree Japan SmallCap Dividend SPDR Russell/Nomura PRIME Japan iShares MSCI Japan Index iShares S&P/TOPIX 150 Index WisdomTree Japan Hedged Equity Ticker JSC SCJ DFJ JPP EWJ ITF DXJ iShares WisdomTree State Street Global Advisors iShares iShares WisdomTree Fund Family State Street Global Advisors 3 mo Return (Mkt) 4.3% 4.2% 6.4% 2.5% 2.7% 2.0% 1.2% 1 yr Return (Mkt) -0.7% -2.0% 0.6% -9.6% -10.9% -12.2% -13.9% 3 yr Return (Mkt) 11.1% 10.4% 10.0% 6.2% 5.9% 5.3% -1.0%

Source: Yahoo! Finance ETF Center accessed on February 8, 2012 http://finance.yahoo.com/etf/browser/mkt?c=etf_js&f=0

28 ETFI ASIA 2012 Q1

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Net assets: the size of an ETF is important in reducing frictional costs and, hence, the expense ratio. A large size also makes it easier for institutions to make investments without violating internal compliance requirements; T The bid: offer spread is more important for short term tactical trades, i.e. trades expected to be closed within a short period of time. ETFs with low average daily trading volumes can have high spreads that detract from the benefits of any ETF trade. However, note that the liquidity of an ETF is closely linked to the liquidity of its underlying investments and not simply to its daily trading averages; Structure: an ETF structure hints at its ability to maintain a low tracking error. Synthetically structured products have inherent limitations in meeting particular objectives. Other than full replication, there are also ETFs which use representative sampling investment methodologies. Investing in countries or regions through ETFs is simple and effective. Typically, ETFs are cheaper than mutual funds. Additionally, the operational ease of executing ETF trades, long or short, makes them valuable tools for portfolio management. Nonetheless, ETFs sometimes also display inherent shortcomings for investors seeking to diversify into countries and regions, especially outside of the major developed stock markets. For investors, finding the optimal ETF solution to meet an investment goal requires an analysis almost as rigorous as valuing an individual stock merely picking the ETF with the closest name is not a good strategy.

from a three-year return of almost 17%. Meanwhile, investors in the small US$18.7 million PowerShares MENA Frontier Countries ETF (PMNA) suffered a loss of over 3% during the same period. Moreover, investors in the US$684 million iShares MSCI BRIC Index ETF (BKF), the popular BRIC (Brazil, Russia, India and China) combination of countries, landed in between with a return of 15.8%.7 After creating a shortlist of relevant ETFs, other more common investment screens associated with ETF investing should be analySed. These include the following: Expense ratio: low expense ratios are a key benefit of ETFs. Many categories have a large number of available ETFs and fees add up over time. While the cheapest ETF is not necessarily the best, cost must factor into an investors final choice;
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For the purposes of this article, the generic term ETF refers to exchange traded portfolios comprised of various structures, including exchange traded notes (ETNs). Y Yahoo! Finance ETF Centre accessed on February 8, 2012. http://finance.yahoo.com/etf/browser/mkt?c=etf_js&f=0 and http://finance.yahoo.com/etf/browser/mkt?c=etf_ch&k=5&f=0&o=d&cs=1&ce=21 Source: All data on JSC and DXJ from Yahoo! Finance accessed on February 8, 2012. Three year return data as at January 31, 2012. http://finance.yahoo.com/etf/browser/mkt?c=etf_js&k=5&f=0&cs=1&ce=20&o=d For the three year period ending January 31, 2012, calculated using historical prices listed at Yahoo! Finance accessed on February 8, 2012. http://finance.yahoo.com/q/hp?s=EWS&a=11&b=25&c=2008&d=01&e=8&f=2012&g=d For the three year period ending January 31, 2012, STI and SGD returns calculated using historical prices listed at Yahoo! Finance accessed on February 8, 2012. http://sg.finance.yahoo.com/q/hp?s=%5ESTI&a=11&b=28&c=2008&d=01&e=7&f=2012&g=d; http://finance.yahoo.com/echarts?s=SGDUSD%3DX+Interactive#symbol=;range=20081225,20120206;compare=;indicator=volume;charttype=area;crosshair=on;ohlcvalues=0;logscale=o ff;source=undefined VIG and DVY data from Yahoo! Finance accessed on February 8, 2012. All data from Yahoo! Finance accessed on February 8, 2012. http://finance.yahoo.com/etf/browser/mkt?c=etf_em&k=5&f=0&o=d&cs=1&ce=35

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How to Rate, Rank and Select ETFs

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