iShares MSCI Germany Sink, as the German Market Seems to Thrive

"Why is [the iShares MSCI Germany(EWG Quote)] going down so much?" asks Brandan Imen. "Germany's stock market seems to be doing well!"

"Seems" is the appropriate word. Actually, when you factor in this year's nasty little collapse of the euro, the performance of the German stock market is nothing to drink a stein of bier about.

But there does appear to be a rather significant difference between the performance of the iShares MSCI Germany, which is a closed-end fund that tracks the Morgan Stanley Capital International index for Germany, and the overall performance of the German stock market, as judged by its benchmark index, the Xetra Dax. That disparity reflects differences in the makeup of the indices, and, most importantly, the exchange rate.

Returns on the iShares are down 19% since the beginning of the year, when adjusted for a dividend distribution in August. The Dax, however, is down only 1.4% for the year. That is a pretty significant gap, especially since the iShare is supposed to be a means to invest in the overall market. Also, because it is a passively managed fund that is benchmarked to the MSCI index, there should be little difference between it and the overall market -- you can't say the fund managers had a bad year, in other words. A disparity of that size could indicate that investors are not quite getting what they bargained for.

However, returns for the iShares are listed in dollars and reflect an exchange into dollars from euros. The Dax, when adjusted for the currency exchange, has actually declined 16%. Thus, a German who has invested with euros in the overall German stock market has had a nearly flat year, but an American who bought the iShares MSCI Germany fund in dollars at the beginning of this year has been hit by a double whammy of flat stock performance and miserable currency performance. This demonstrates one of the fundamental risks in investing overseas.

Likewise, whenever the euro rebounds -- and it will someday -- it will boost the returns for U.S. investors.

Nonetheless, there is still a gap of three percentage points between the iShares and the Dax. That discrepancy can be explained by the makeup of the two indices. The Dax includes only 30 companies, while the MSCI Germany index has 52.

"MSCI has broader market coverage," says Lisa Chen, portfolio manager for the fund. "The Dax is more concentrated." The MSCI index covers a broader range of sectors in the market and maintains percentages in those sectors. So even though there are more companies in the MSCI Index, some companies in the Dax are not in the MSCI index, such as Henckel, Commerzbank AG and Bayerische Motor, because including them would increase the weighting of their respective sectors in the index.

Thus, tracking the MSCI index offers more diversification and investing in a broader swath of the market. While the Dax may outperform the MSCI index -- and this is true for any other country from time to time -- it may underperform as well.

But how does the MSCI compare to its country-specific competitors? The closed-end Germany Fund(GER Quote) is down 14.8% this year and the closed-end New Germany Fund(GF Quote), which focuses more on small- and medium-cap stocks, is down 7%. Those funds are actively managed funds, and clearly, the managers of the Germany Fund have had a slightly better year than the overall market, while the managers of New Germany Fund have done much better.

All of which, of course, demonstrates the pros and cons of actively managed mutual funds that offer the potential of outperforming a market vs. passively managed mutual funds, which offer the security of matching the market. And that is an argument that not even Warren Christopher and James Baker could hope to resolve.