As an investor, it’s reassuring to know that there’s always – somewhere – a bull market going on.
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For example, when the Asian financial crisis slammed Southeast Asia’s economies in 1997 – with some markets losing 80 percent of their value in 12 months – the Dow Jones Industrial Average soared 24 percent over the next year.
And when the S&P 500 dropped 21 percent and the Nasdaq collapsed 71 during the dot-com bust, China’s Shanghai Composite Index was a safe haven, delivering a 6 percent gain.
More recently, with major Asian markets down between 5 percent and 14 percent since the start of the year on growing trade war tensions, the Russian stock index is up a respectable 11 percent (maybe even partly thanks to the “World Cup Host Effect,” which we wrote about here.
Given perfect capital mobility, you could hop from one market to the next, avoiding bear markets and finding bull markets all across the world.
For the smart money, being able to do this is an enormous advantage.
And thanks to the growing popularity and increasing variety of exchange-traded funds (ETFs), country-specific asset reallocation is at the fingertips of everyday investors.
An ETF for every country
ETFs are financial products that offer the benefits of pooled investing. ETFs are great tools to diversify your portfolio in a financial instrument that is professionally managed and regulated.
ETFs, by nature, are traded on a stock exchange and can be bought or sold just like any regular listed-company share.
As for their stock holdings, an ETF often tracks a benchmark – an existing index like the S&P 500 Index or the MSCI China Index – and is designed to track its performance as closely as possible.
The first ETF that was ever offered was the SPDR S&P 500 ETF (NYSE; ticker: SPY), which was launched in January 1993. It’s designed to provide investment results that, before expenses, generally correspond to the price and yield performance of the S&P 500 Index.
Because of the convenience it offered to ordinary investors and fund managers, SPY became enormously popular. Today, it holds more than US$250 billion in assets under management.
Since then, hundreds of ETFs have been created on exchanges all around the world. As of the end of 2017, the total assets held by ETFs was an astonishing US$5 trillion. You can invest in almost any asset with an ETF. And moreover, of the 60 stock exchanges around the world, there are now 44 countries with ETFs.
These markets have ETFs that are traded in New York, which makes them accessible to investors who can buy U.S.-listed shares. Other markets across the world have listed country ETFs as well.
But if you’re looking to mimic the actual stock market movement in countries through ETFs, buyer beware.
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This is why country ETFs underperform
One common misconception about country ETFs is that they perform largely in line with their respective stock exchange indices. For example, the SPY should perform similarly to the S&P 500 Index.
But a closer look at many of the largest country ETFs tells a different story.
The table above shows the one-year and five-year performance of major listed country ETFs relative to the stock exchange index of the country they look to replicate.
Out of the 10 country ETFs shown above, only one of them has outperformed its underlying stock market. That’s the iShares China Large-Cap ETF (NYSE; ticker: FXI).
The other nine ETFs underperformed their underlying markets, with many of them grossly underperforming in the long term.
The iShares MSCI Japan ETF (NYSE; ticker: EWJ), for instance, underperformed the Nikkei 225 Index by an enormous 18.4 percentage points over the last five years.
Looking at India, one of the world’s best-performing markets in recent years, the Invesco India ETF (NYSE; ticker: PIN) underperformed the Nifty 50 Index by 16.3 percentage points.
There are many reasons why country ETFs underperform their underlying stock markets.
One of the biggest is that country ETFs often follow benchmarks that differ in composition and weighting from the stock market indices themselves.
For example, the Invesco India ETF tracks the Indus India Index as its benchmark instead of the Nifty 50 Index. And while the Indus India Index is designed to represent the Indian equity markets as a whole, with 50 Indian stocks spread among various sectors, they aren’t the same as those that make up the Nifty 50 Index.
The two largest holdings of the Invesco India ETF are conglomerate Reliance Industries (10 percent) and technology giant Infosys Limited (10 percent). But the two largest holdings in the Nifty 50 Index are banking stocks, HDFC Bank (9.4 percent) and HDFC Limited (7.5 percent).
Another reason country ETFs underperform is expenses. Investors have to pay fees regardless of whether the value of the ETF rises or falls. This has the effect of hurting the ETF’s performance relative to the underlying benchmark index (which carries no fees).
Most country ETFs have annual expense ratios ranging between 0.5 percent to 0.7 percent. That means even if the fund matched the index perfectly,, the performance of the fund would lag that of the index.
But as long as you’re able to identify countries that are about to experience above-average growth for a sustained period (such as Bangladesh, which we’ve written about previously here and here), the potential gains should more than offset the ongoing expenses.
Country ETFs are still safe and reliable ways to diversify from you home market and into markets experiencing significantly better growth and potential. But it’s important to consider that they can still underperform their underlying country indices over the long term. And they do have ongoing fees that will start to eat away at your capital the longer you hold them.
Editor, Stansberry Churchouse Research