The earthquake in Japan highlights the difference between what many investors see as the right way and the wrong way to use single-country exchange-traded funds.
ETFs have attracted fans by slicing and dicing the stock market in hundreds of different ways. No fewer than seven different ETFs target Japanese stocks, including the $6.2 billion iShares MSCI Japan Index ETF and the $250 million WisdomTree Japan Hedged Equity Fund.
Many investors who trade these funds won't be hurt more than investors in broad market international funds, even if damage from the earthquake further undermines Japanese stock prices. The reason is that they don't buy single-country ETFs as a big bullish bet on the country in question, which would be the wrong way.
Instead, the funds are purchased the right way — as a small piece of a much broader portfolio that simultaneously includes other funds targeting different countries or regions. Owning several different international funds allows portfolio managers to make small tweaks to an investment portfolio that otherwise largely resembles the market as a whole.
An example is the $1 million hypothetical portfolio that Morgan Stanley Smith Barney publishes as a guide for its financial advisers. The model typically includes 21 different ETFs, including six different funds focused on international stocks. Together, the international stock roster, which includes two single-country funds, the iShares MSCI Canada Index ETF and the iShares MSCI Japan Index Fund, represents about a third of the hypothetical $1 million, or $320,000.
The brokerage's investment analysts recently trimmed holdings of the Japan fund from 3% of the total portfolio in October, to zero today. The Canada fund has held steady at 3% of the portfolio. The reason is that Morgan Stanley Smith Barney's researchers prefer to slightly overweight emerging-market stocks, based on factors like earnings growth, government balance sheets and debt levels. Among developed countries, Canada is favored because of its commodity-heavy economy.
Investors who follow the model would still have some Japanese stock exposure. Another ETF the model recommends, the iShares MSCI EAFE Small Cap Index Fund, has some Japanese holdings. Of course, many U.S. companies also do business in Japan, giving investors indirect exposure to the country's fortunes, too.
Still, an investor who followed the model portfolio would almost certainly have less Japan exposure than one that bought a broadly focused option like the iShares MSCI ACWI ex-U.S. Index Fund in place of the six different funds Morgan Stanley Smith Barney proposes. The iShares MSCI ACWI ex-U.S. is as broadly focused as it gets, targeting stocks from around the world, based on their market values.
Japanese stocks make up about 15% of the fund.
