Placing Bets on the Lucky Country

08/23/2010 11:01 am EST

Focus: ETFS

Paul Justice

Associate Director of North American ETF Research, Morningstar, Inc.

Paul Justice, Morningstar’s director of North American ETF Research, and analyst Patricia Oey say an ETF tracking Australian stocks is a good way to play Asian growth.

An investment in iShares MSCI Australia Index (NYSEArca: EWA) is sometimes viewed as an indirect play on economic growth in China and the Asia region, given its 30% weighting in export-focused materials and energy companies.

China is also Australia’s largest trading partner. While growth in China is expected to slow in the near term, we expect growth in the medium term to remain healthy.

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 global economic downturn that started in 2008, Australia fared better than most. Its banking system is highly regulated and had limited exposure to toxic assets.

Partially due to China’s rapidly growing need for products such as coal and iron ore, exports of minerals have grown from 20% of Australia’s exports to more than 40% in the past decade. Australia is currently the world’s largest exporter of iron ore and coal and, in a few years, it will also be a top exporter of liquidfied natural gas.

However, 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. There are also concerns that the Australian economy could become overly dependent on commodities.

Financial-services companies could provide some stability in the near term. Australia’s big four banks have maintained healthy balance sheets and remained profitable through the global economic crisis. And while the big four are not allowed to merge with each other; they are allowed to acquire smaller assets.

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; it includes about 70 companies. (Australia also had the world’s best performing market over the past 109 years—Editor.)

This fund has heavy weightings in financials (which account for 45% of the portfolio) and materials (26%). This fund’s largest holdings, such as BHP Billiton (NYSE: BHP) [and]  Rio Tinto (NYSE: RTP), sell commodity products whose demand and pricing can be very volatile.

As a single-country fund, EWA should be considered a satellite holding. For most US investors, we recommend a total foreign asset allocation of up to 25% of a total portfolio, which can easily be achieved using broader funds. Also, within an international (ex-US) fund, Australia can account for about 5% to 9% of a portfolio.

Investors looking for a little more geographic diversification can consider iShares MSCI Pacific ex-Japan Index (NYSEArca: EPP), in which Australia accounts for about two- thirds of the portfolio. (The other markets included are Hong Kong and Singapore.)

International ETFs tend to have higher expenses relative to domestic ETFs. We think EWA’s expense ratio of 0.55% is reasonable.

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