Country-Specific ETF: Be Careful What You Wish For

One of the many uses for ETFs is to gain exposure to a particular country's equity markets quickly and cheaply to diversify a portfolio or speculate on economic growth. For most investors, an ETF tracking a country's benchmark index is a much better option than investing directly in stocks from that country, as it is more efficient to buy one ETF than to create a portfolio of multiple stocks. However, that doesn't mean you can blindly purchase any country-specific ETF without doing your homework. In addition to examining the expense ratios, and trading costs, and choosing between a physical-replication or swap-based ETF, investors need to look at the composition of a country-specific ETF to see just what you're getting with your purchase.

There are around 200 country-specific ETFs currently trading in Europe, ranging from ETFs tracking large economies like China and the US all the way down to relative minnows like Finland and Belgium. While ETFs from large countries tend to be naturally diversified, small country ETFs can be heavily concentrated in one area. In some cases, a single company can dominate a small country's stock market; for example, Nokia's market cap is roughly one-third of the market cap of Finland's entire stock exchange. While this is an extreme example, it is definitely something that investors need to look out for when delving into single-country ETFs.

One way to mitigate the problem of a single company taking up too large a position in an ETF is to cap the size of the exposure to any one company. A capped ETF follows its benchmark index like any other ETF, except that the allocations to any one company are capped at a certain percentage. In some cases, the index itself is capped. To use our Finnish example once more, the Helsinki 25 Index caps the contribution from any one company at 10% of the overall market cap. In fact, most ETFs traded in Europe will be capped in one way or another, as UCITS restricts the weight of any single security in an ETF to 10% of the total assets, with the top five securities limited to 40% of total assets.

While this limit is helpful, it can still leave a country-specific ETF concentrated in a particular sector. Oil and gas, telecom, and financial companies can often be large enough that they skew a country's index towards those sectors. For instance, the Dow Jones Turkey Titans Index has more than half its assets in financials. This phenomenon is not only limited to the smallest economies, but can also happen in larger countries like Brazil (the Bovespa Index has about 25% of its assets in two resource extraction giants, Petrobras and Vale), or in more developed economies like Australia (the S&P ASX 200 Index has more than half its assets in the top-10 companies, and financial services and industrial materials comprise almost two-thirds of its sector weightings). Even if you view a particular sector favourably, in most cases it is better to play that hunch by investing directly in an ETF of that sector, which can offer more diversification globally.

If, however, you are interested in diversifying your currency exposure, a country-specific ETF can be an effective method of accomplishing this task. While there are currency-specific ETFs available, it is almost always preferable to hold onto a broad-based equity ETF composed of companies who operate in that currency. With a country-specific ETF you are earning dividends and capital gains, while with a currency-specific ETF you are only exposed to changes in the exchange rate, a zero-sum game best left to professional traders.

Once you decide on a particular country to invest in, the real work begins. In terms of index providers for country-specific ETFs, MSCI, DJ and FTSE dominate, accounting for almost 60% of all benchmark indices tracked. Most of the rest tend to be exchange-specific indices, like the NASDAQ in the US or the DAX in Germany. With a larger country like the US, along with a choice of different indices to track, you also have a full range of options available like small-, mid-, and large-cap specific funds, dividend funds, leveraged funds, inverse funds, etc. Be sure to consider your entire portfolio when choosing among these options, as you should include exposure to different market cap sizes and styles to diversify properly.

In Europe, after the DJ Euro Stoxx 50, ETFs following the DAX are the most popular choice for investors. This popularity tends to make these ETFs a good investment option because not only does it mean that there are multiple ETFs available from nearly every large provider, but high volumes and competition between market makers for this business leads to narrow bid-ask spreads. There is enough interest from investors in large countries like Germany to provide ample liquidity, but smaller countries with less-developed capital markets may find it more difficult to attract attention from big institutional investors with billions to allocate. This could lead to large bid-ask spreads in ETFs specific to these countries, and may make it difficult to exit in the event of a market crash.

There can be a place in your portfolio for country-specific ETFs, but choose wisely. Because of the concentration in a specific economy, currency, and often sector or company, these funds often do not benefit from the diversification that is the main advantage of the ETF as an investment vehicle. With the lower diversification you are taking on a higher risk without any extra expected return. While this effect can be mitigated by investing in a broad array of ETFs tracking indices from different countries, we think in most cases that large, regional ETFs like those following the DJ Stoxx indices should form the core of an investor's equity portfolio.