Two Faces of Single-Country Funds

PRESCOTT, AZ (TheStreet) -- In the last 10 years, do-it-yourself investors have become increasingly aware of the importance of foreign investing. The response from the ETF industry has been to create many types of funds that offer many types of exposure, including single-country funds.

iShares dominates the single-country fund space in terms of both number of funds and assets under management. iShares initially bought its way into the segment by acquiring the old World Equity Benchmark Shares, or WEBS, product line from Morgan Stanley; the number of funds available since then has increased significantly.

Constructing a portfolio that includes individual country funds requires two layers of analysis and research. The first layer is what might be expected in terms of a top-down study of the country's fiscal condition, economic stats, what it is that makes the economy of that country tick and any risk factors.

A simple example is the WisdomTree Australia Dividend Fund ( AUSE). Australia has a debt-to-GDP ratio of 22%, which is well below the U.S. Its budget deficit was 4.1% last year. The unemployment rate just dropped to 5.2% and the published rate of inflation is a little over 1%. Obviously abundant natural resources is what makes the economy tick; more precisely, global demand for natural resources. The current risk factors would seem to focus on an over-extended housing market.

The role that Australia could play in a diversified portfolio would be to offer exposure to a resource-based economy, which is likely to be at a different point in the economic cycle than a service-based economy like the U.S. This means Australian exposure offers a chance of better portfolio diversification vs. buying another service-based economy like one in Western Europe.

This example is simple, as is the case with many countries. Investors would need to decide whether the attributes and prospects of a given country are compelling enough to include in the portfolio. This process would be undertaken with several countries, maybe more, to build a diversified portfolio.

This can be preferable compared to using a broadly diversified fund like the iShares MSCI EAFE Index Fund ( EFA), because that fund has exposure to many unhealthy countries that should be avoided and will likely continue to struggle. These countries include Japan and most of the Eurozone.

The second layer of analysis is to look under the hood of a country fund to understand the holdings and how those holdings might fit in with other funds or individual stocks held in the portfolio.

For example, the iShares MSCI Singapore Index Fund ( EWS) has approximately 50% in financial stocks and the Global X Norway ETF ( NORW) has 50% in energy stocks. It is not a problem that these two funds are so lopsided into one sector. A problem could arise in building a portfolio that has many funds with 50% in financials.

This is where problems occur. A portfolio of funds ends up being grossly overweight a sector that then goes on to implode for the simple reason of never taking the time to look under the hood. This problem is easily avoided with ETFs because of their transparency. An ETF investor can simply go to the Web site for his funds, get the weightings and then do the math.

The other important part of looking under the hood is to isolate any single-stock risk that a fund might pose due to a concentrated position in one or two stocks. Look at NORW, mentioned above, a fund that has a 20% weight in Statoil ( STO). Any investor interested in NORW should take a little time to understand Statoil and follow the stock somewhat after purchasing NORW. Anyone drawing a negative conclusion on Statoil should probably avoid this fund.

Finally, it also makes sense to understand the risk mathematically in owning an ETF with such a large position in one stock. If somehow Statoil were to drop 75% overnight on some sort of catastrophic news, someone with a 10% portfolio weight in NORW would be looking at a 1.5% hit to his or her portfolio. While that would be unfortunate, it would not cause someone to have to rewrite his or her financial plan.

At the time of publication, STO was a Nusbaum client position.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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