To this point in 2010, investors around the globe have paid close attention to every development in the euro zone, as crumbling public finances in the region have threatened to spark a wave of crippling defaults and have called into question the sustainability of the common currency. Most of the attention has focused on Greece, where a skyrocketing public deficit has set the stage for a downgrade of sovereign debt to below investment grade.
While Greece’s financial mess is less than ideal for the euro zone, the relative size of the country’s GDP and debt burden have put some investors at ease. While many wealthy EU members have expressed publicly their opposition to a Greek bailout, such a move would be very doable. The problem is that Greece isn’t the only trouble spot, and providing sufficient aid to other distressed economies would be much more of a challenge.
Spain is the euro zone’s fourth largest economy, and its economic troubles, by some measures, make Greece look like a thriving superpower. Unemployment is 19%, and youth unemployment is twice that level, casualties of a battered construction sector. GDP contracted by 3.6% in 2009, and is expected to decline again in 2010. Massive stimulus spending has caused the budget deficit to swell to more than 11% of GDP, far above euro zone limits and on par with Greece’s crumbling public finances.
With Spain’s economy at a critical juncture, Spanish equities have seen a jump in trading volumes, as some investors distance themselves and others race in sensing short-term opportunities, both long and short. The iShares MSCI Spain Index Fund (EWP) has sunk by about 17% this year, and trading volumes have surged in recent weeks.
EWP is composed of about 30 publicly-traded Spanish securities, and is the only U.S.-listed ETF to focus exclusively on Spanish markets. But for investors who think they’re making a play on the local Spanish economy through this fund, a look under the hood may reveal some interesting truths.
Brazil And Beyond
The index to which EWP is a cap-weighted benchmark that aims to capture 85% of the publicly available market capitalization of the Spanish market. As such, its largest holdings are in mega-cap Spanish companies. While these companies are listed on Spanish exchanges, many of them derive only a portion of their revenues within Spain. While this isn’t unusual–many European companies generate revenues from throughout the region–it is interesting to note that a significant portion of profits of major Spanish companies comes from developing markets outside of Europe.
Banco Santander, which makes up nearly a quarter of EWP, generated about 36% of its profits from South America in 2009, compared to only about 26% from Spain. Telefonica, which makes up about 18% of the Spain ETF, derives about 40% of earnings from Brazil and other South American markets. Banco Bilbao, EWP’s third largest holding, makes more than half of its income from the South America.
|Spain ETF (EWP)|
|Company||% of EWP||% Profit From S.A.
|Source: iShares.com, company financials|
Iberdrola Group, EWP’s fifth largest holding at about 5% of assets, generates only about 40% of its revenue in Spain, with the UK, U.S., and South America accounting for the rest.
EWP is by no means a flawed product. Far from it in fact. It has accomplished its stated objective–to track the performance of the MSCI Spain Index–with impressive efficiency. The expense ratio of 56 basis points is a bargain for international exposure, and the liquidity of the fund’s shares is sufficient to maintain a tight bid/ask spread.
But any investor who thinks he or she is making a pure play on the local Spanish economy should take a closer look. EWP is more likely to be impacted by monetary policies in Sao Paulo than by unemployment in Sevilla.
Large Cap vs. Small Cap
EWP isn’t alone. Most international ETFs available to U.S. investors are tilted towards mega-cap stocks that maintain global operations and generate significant revenues beyond their home country. Virtually every company in the S&P 500 SPDR (SPY) is a multi-national firm that depends more and more on demand from China and other emerging markets to drive growth.
So the bad news is that there are some limitations to gaining international exposure through ETFs. But the good news is that there is significant room for expansion in this corner of the ETF industry. A handful of funds offering exposure to small cap companies in international markets have already been launched, including Van Eck’s Brazil Small-Cap ETF (BRF), Claymore’s China Small Cap Index ETF (HAO), and iShares’ MSCI EAFE Small Cap Index Fund (SCZ). An in-depth analysis of the performance of these small cap international ETFs relative to their mega-cap counterparts reveals, not surprisingly, that there are very different risk and return profiles between the two.
The lesson–as always–is to know what you own. For more looks “under the hood” of ETFs, sign up for our free ETF newsletter.
Disclosure: No positions at time of writing.