Getting to China from Down Under

02/24/2012 8:45 am EST


Sometimes the direct approach isn’t the best approach, especially since most people are trying to crowd into that door when there’s another way that’s much more efficacious says Patricia Oey of Morningstar ETFInvestor.

Investors looking for exposure to China don’t have to limit their options to Chinese equity exchange traded funds.

This month, we highlight iShares MSCI Australia Index (EWA), which can be shorted by investors concerned about a hard landing in China’s real-estate sector, as China’s rapidly growing demand for Australia’s commodities has been an outsized driver of GDP growth in Australia during the past few years.

IShares MSCI Australia Index is an ETF that will benefit from economic development in the emerging markets, especially China, over the next few decades. Australia is uniquely suited to benefit from China’s growth, thanks to its location and abundance of iron ore and coal. As a single-country fund, we think EWA is suitable as a satellite holding.

The Australian dollar is considered a commodity currency, which gradually appreciates when demand for commodities is strong. However, commodity currencies are susceptible to sudden declines during periods of high market volatility, which unfortunately has been more frequent over the past few years.

In the past decade, the strong appreciation of the Australian dollar against the US dollar has been a significant source of returns for this fund. But in 2008, the Australian dollar’s 28% decline contributed to EWA’s 50.2% fall. Investors should be aware that when markets are in a “risk-off” mood, this fund can drop fast due to falling asset prices and currencies.

Because of the volatile Australian dollar, this ETF’s riskiness is more in line with that of emerging-markets equities. Through December 30, this ETF’s annualized five-year standard deviation of returns was 30%.

However, we note that the volatility of the MSCI Australia Index, in Australian dollars, at 16%, was slightly lower than that of the S&P 500. This reflects the quality and stability of Australia’s large-cap companies, which dominate the index.

Australia is not part of the Asian continent, but is sometimes included in funds that invest in the Asian region. As a result, Australia could range from a 0% weighting to a 75% weighting in an Asia fund…so it is important for investors to check their existing Australia exposure before buying this ETF. Also, within an international (ex-US) fund, Australia usually accounts for about 5% to 9% of a portfolio.

The Australian economy has prospered in recent years, buoyed by the nation’s ample natural resources and supported by a stable government and economy. During the 2008 global financial crisis, Australia fared better than most. Its banking system is highly regulated and had limited exposure to toxic assets.

But more importantly, Australia continues to benefit from its growing trade relationship with Asia. Its top four export markets are Japan, China, Korea, and India. The US is its fifth-largest export market.

Partially thanks to China’s rapidly growing need for products such as coal and iron ore (a key input for the production of steel), minerals have grown from 20% of Australia’s exports to more than 60% in 2010.

At this time, China accounts for more than 60% of Australia’s iron-ore exports. And while Australia is currently the world’s largest exporter of iron ore and coal, in a few years it will also be a top exporter of liquefied natural gas, thanks to recent and planned large investments in the LNG industry. The new LNG projects have already secured supply contracts with gas companies across the Asian region.

The obvious near-term risk to this fund is a potential fixed-investment slowdown in China following a building binge that has accelerated over the past few years. We also highlight that there have been increasing tensions between China and Australia regarding iron-ore pricing and Chinese investments in Australia. A major trade dispute could potentially weigh on Australia’s economic health.

And finally, slowing global growth will weigh on commodity prices, which will negatively affect the companies in this fund that are directly and indirectly tied to commodity production.

This ETF tracks the MSCI Australia Index, which is a capitalization-weighted index that aims to capture 85% of the publicly available total market capitalization of stocks that trade in the Australia market. The index consists of 71 holdings. The fund managers employ a sampling strategy to replicate the index’s performance, and in the past ten years have maintained a fairly low tracking error.

This ETF has a relatively high dividend yield of more than 4%, which is paid semiannually. Dividends from foreign-domiciled companies can be subject to foreign tax withholding and may not be considered qualified. However, historically, this ETF has experienced almost no foreign tax withholding, and all distributions have been considered qualified.

International ETFs tend to have higher expenses relative to domestic ETFs. We think EWA’s expense ratio of 0.52% is reasonable.

EWA is the cheapest and by far the most liquid ETF to provide exposure to Australian companies. Investors seeking less exposure to Australia’s big four banks and large-cap mining companies can consider WisdomTree Australia Dividend (AUSE).

AUSE tracks an index consisting of the largest dividend payers from ten sectors, weighed by market capitalization. The fund has an average market cap of $7 billion, and is currently yielding about 6%. However, this fund trades on very thin volume.

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