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Posted by on Feb 27, 2014 in ETF Strategist

The Important Role of Country Funds in a Diversified Portfolio

by Roger Nusbaum AdvisorShares ETF Strategist

As most investors know, foreign equity markets have had a rough time of things performance-wise for the last couple of years relative to domestic equity markets. While Quantitative Easing may or may not be to blame, after years of generally outperforming the US in the previous decade the new decade has been a different story.

Back when foreign was outperforming, investors took the time to learn about single country funds which is a space that was and still is dominated by iShares. The original country funds were branded as WEBS by Morgan Stanley back in the 1990s which stood World Equity Benchmark Securities which was shortly thereafter sold to iShares. Funds in this original suite include what is now iShares funds tracking countries like Japan, Switzerland and Brazil along with several others. iShares has since gone on to expand the product line dramatically.

Since then, many providers have come out with suites of country funds, regional funds and other ETFs that one way or another offer foreign exposure that goes narrower than funds tracking broad indexes like MSCI EAFE Index or the MSCI All Country World Index.

As the space has evolved there are now multiple funds for Colombia, Norway and Poland as well as funds targeting Nigeria and Mongolia.

Using country funds is valid as part of a diversified equity portfolio but advisors/investors seeking this type of exposure need to be ready for multiple layers of work. In addition to forming an opinion on a given country’s prospects the potential end user of a country fund needs to consider the holdings in the fund.

For example over the years the MSCI Singapore Index has offered multiyear periods of massive outperformance versus the S&P 500. Singapore’s index though takes on serious concentration in the financial sector. That sector has always had about a 50% weighting in the fund, currently it is at 52% according to the iShares website. It is unlikely that an investment tracking Singapore would be able to do well if the financial sector cuts gets crushed during some sort of regional panic that tends to occur in the region every few years.

Another type of risk in some country funds is when one stock has a disproportionately large weighting in a fund. For example the Danish market has a massive in a drug company specializing in diabetes. An investor drawing a favorable conclusion on Denmark would want to take the time to learn about that company. It would not make sense to buy a fund tracking Denmark while having a bearish opinion on the stock dominating the index.

Similarly, after owning Denmark for some period of time the fundamental picture for that drug company could change for the worse which could make the fund better to sell at that point even if the top down story for the country is better than ever.

Not all country indexes have concentration issues like this of course. France has no sectors greater than 20% and although a couple of stocks in the fund come close to 10% weightings the fund is not beholden to those names the way certain less diversified funds are.

Foreign investing with country funds was a huge driver of returns in the previous decade but less so in the 1990’s. Now after a run where foreign has mostly lagged domestic it is logical to expect the pendulum to swing back the other way and when that occurs country funds will again drive returns.

Investors can do this themselves or seek out a managed solution but either way the space should not be ignored.