5 Things To Watch Out For In International Equity ETFs

by on January 18, 2012

As the ETF universe has expanded dramatically over the last several years, many investors have taken advantage of this asset class to tap into international equity markets. With single-country ETFs dedicated to dozens of developed and emerging markets, accessing the major (and not-so-major) stock markets around the globe has never been easier. 

When evaluating international equity ETFs–as with all ETFs–it is important to take a look under the hood and fully understand what the portfolio includes. Below, we highlight a few relatively common characteristics of international stock ETFs that might be somewhat disconcerting to investors [for more ETF insights, sign up for the free ETFdb newsletter]:

1. Major Sector Biases

Many international equity ETFs feature some big tilts towards certain sectors of the economy, giving heavy weightings to certain types of companies while overlooking others altogether. That can result in concentrated risk for investors, especially when ETFs highlight sectors such as energy that can be impacted by often volatile commodity prices.

The iShares MSCI Taiwan Index Fund (EWT) has about half of its holdings in tech stocks, reflecting the tech-centric nature of the Taiwanese economy at present. But in most international equity ETFs, it is energy, financials, and materials that get the biggest allocations in the sector breakdown. The reason for that tilt is straightforward; banks, energy companies, and mining firms are often the largest companies in an economy, meaning that they receive the biggest weighting in cap-weighted benchmarks.

Consider some popular international equity ETFs with big tilts towards these corners of the market:

Ticker Name Energy % Financials %
FXI iShares FTSE China 25 Index Fund 15.0% 52.9%
EWM MSCI Malaysia Index Fund 0.0% 28.8%
EWC MSCI Canada Index Fund 26.3% 27.8%

These big concentrations are not inherently a flaw in these products; it is important to keep in mind that in many cases they simply reflect the composition of the underlying economy [see Global Titans ETFdb Portfolio]. Canada is home to big banks and big oil firms. Many of the largest companies in China are financial institutions. But it is certainly worth noting when analyzing potential opportunities.

2. Single Stock Concentrations

Concentration in international equity ETFs is not only an issue from a sector perspective; many products targeting stock markets outside the U.S. have hefty weightings to a single company:

Ticker Name Top Holding
EPU MSCI All Peru Capped Index Fund  Buenaventura Mining (18%) 
EWZ MSCI Brazil Index Fund  PetroBras (18%) 
EWP MSCI Spain Index Fund  Telefonica (21%) 
EWI MSCI Italy Index Fund  Eni SpA (22%) 
EWW MSCI Mexico Index Fund  America Movil (24%) 

Again, this concentration isn’t necessarily a drawback; if the top holding performs well it can give a boost to the entire ETF. But the company-specific risks in the ETFs highlighted above is obviously significant; investors in these funds might not be getting the diversification they expect, and a slide in the stock price of a single company can end up weighing on the entire fund [try our Free ETF Stock Exposure Tool]. 

3. Overseas Exposure

In an increasingly interconnected global market, finding “pure play” exposure to an international market can be challenging. Many components of international stock ETFs generate their revenues and profits in a number of countries, in some cases relying primarily on international markets for the bulk of earnings [see ETFs To Round Out Your International Exposure]. Just as Coca-Cola relies heavily on markets outside the U.S., many of the components of international ETFs rely on demand from the States and other regions of the world to drive demand.

Take the iShares MSCI Spain Index Fund (EWP) as an example; this popular ETF has Telefonica (21%) and Banco Santander (18%) as the two largest holdings. Both of those companies count on Brazil for a big chunk of earnings and an even larger portion of growth. Spain is still a key market, but hardly the only driver of those two companies (and therefore the entire ETF).

EWP isn’t the only example of this phenomenon; most international equity ETFs have meaningful allocations to multi-national companies. Some have embraced small cap ETFs as a way to get “closer to the ground” in international markets; these funds are less likely to consist of the types of companies that maintain major international operations and more likely to rely heavily on domestic consumption [see Small Cap ETFdb Portfolio].

4. Currency Impact

When establishing a position in an international equity fund, the primary consideration of most investors focuses on the prospects of the underlying stock market. It can be equally important to analyze the outlook for the local currency as well, since exchange rate fluctuations can have a major impact on the dollar amount of an overseas investment. A strengthening local currency can boost returns to U.S. investors, while a depreciating currency can erode and positive returns generated or exacerbate losses [see For ETF Investors, Currency Exposure Matters].

It’s important to note that this factor can work in both directions. During the past year, for example, investments in Japanese stocks have been aided by a strengthening yen while returns to Brazil ETFs have been partially eroded by a slumping real.

5. State Owned Companies

When the U.S. government took on ownership stakes in several large banks and a behemoth auto manufacturer a few years back, it was major news. But in many countries, big government stakes in companies is not the least bit out of the ordinary. Many international equity ETFs have big weightings afforded to companies that are partially state-owned, a distinction that is not immediately obvious from viewing a list of holdings. The presence of the government as a major shareholder can be a red flag to investors, since it introduces the possibility that the company will be operated in a way that is not in the best interests of its shareholders at all times.

The iShares FTSE China 25 Index Fund (FXI) consists almost entirely of companies in which the government has a major ownership stake, as do a number of other China ETFs. But it isn’t only emerging markets where the government has been known to maintain a significant ownership stake; this is fairly common in some European countries as well. For example, Eni SpA makes up about 22% of the iShares MSCI Italy ETF (EWI). The Italian government owns a 30% golden share in the company, which could be problematic if the cash crunch in Italy continues and the government becomes desperate to raise capital [see Three Long/Short Ideas For Euro Zone Debt Drama].

Disclosure: No positions at time of writing.