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IndexIQ, the ETF issuer best known for its funds that seek to replicate hedge fund strategies with liquid, transparent securities, announced today the launch of two new ETFs offering single-country equity exposure. The IQ Canada Small Cap ETF (NYSEARCA:CNDA) will track the performance of the IQ Canada Small Cap Index, while the IQ Australia Small Cap ETF (NYSEARCA:KROO) will seek to replicate the IQ Australia Small Cap Index.

While existing products track the Canadian and Australian equity markets, these will be the first to focus on small cap stocks in these countries. “Investors targeting Canada or Australia typically have been required to invest in funds with broad-based exposure to large cap and global companies domiciled or operating in these markets,” said Adam Patti, chief executive officer at IndexIQ. “However, these domestic economies have their own important dynamics, driven by oil, gas, and metals production in Canada, and coal and metals production in Australia. CNDA and KROO are vehicles dedicated to providing investment exposure to the domestic growth potential of these two countries.”

Expanding International Exposure

One of the emerging trends in the ETF industry over the last year has been increased granularity in international equity markets. While there are ETFs available to U.S. investors that target nearly sector and sub-sector of the domestic economy, options for international exposure are still relatively limited. While nearly every corner of the globe is accessible through a U.S.-listed ETF, many international equity funds are dominated by mega-cap equities that generate revenue and profits from various markets around the world. As such, these ETFs may not offer investors the same exposure to the local economy that small cap funds would.

Small Cap ETFs

Region Ticker
Brazil BRF
China HAO
Japan JSC, SCJ
Emerging Markets EWX
Europe DFE
Canada CNDA
Australia KROO

Brazil is a good example. Since its launch in May 2009, the Market Vectors Brazil Small Cap ETF (NYSEARCA:BRF) is up about 87%. Over that same period, the iShares MSCI Brazil Index Fund (NYSEARCA:EWZ), which invests primarily in mega-cap multi-national stocks, is up about 52%. It’s unlikely that small caps will always outperform large caps–the exact opposite will probably occur at times–but the huge return gap between these funds demonstrates that small cap Brazilian stocks maintain a significantly different risk profile than their large cap counterparts.

Already a number of small cap international ETF options have been launched, and KROO and CNDA now join this list. Other ETFs offering exposure to small caps in various international markets are presented in the adjacent table.

Australian Small Caps

Australia ETFs

Financials 44.6% Materials 26.9%
Materials 25.8% Discretionary 24.6%
Staples 9.8% Industrials 10.7%
Energy 6.5% Financials 10.2%
Industrials 4.4% Staples 10.0%
Reflects data for EWA as of 3/19/10 and for the IQ Australia Small Cap Index as of 2/28

Australia presents a compelling investment case in the current environment, recently becoming the first G-20 country to raise interest rates following the global recession. Australia’s economy is expected to expand by between 3% and 4% in 2010, a significantly higher growth rate than those expected for other developed economies. Moreover, Australia has become one of China’s largest trading partners in recent years, as demand for raw materials produced in Australia’s mines has surged as China’s growth has accelerated.

Prior to the launch of KROO, the only ETF offering pure play exposure to Australian equities was the iShares MSCI Australia Index Fund (NYSEARCA:EWA). While both of these ETFs target Australian equities, their composition will be very different. The index underlying KROO has an average market capitalization of about $1.3 billion, compared to $47 billion for the MSCI Australia Index. EWA consists of about 75 equities, and has its heaviest allocations to financials and materials sectors (45% and 26%, respectively). KROO’s index makes an allocation of only about 10% to financials, with consumer discretionaries accounting for a big chunk (nearly 25%). Less than 3% of EWA’s holdings are currently in the discretionary sector.

Canadian Small Caps

The case for an investment in Canadian small caps centers around the country’s position to benefit from increased global demand for energy. Canada is the world’s third largest natural gas producer and seventh largest oil producer. Canada is also one of the few net exporters of energy-related commodities, and is the largest supplier of oil, natural gas, uranium, and electricity to the U.S.

Not surprisingly, the index underlying CNDA makes its largest allocations to the materials (50.5%) and energy (19.8%) sectors. The iShares MSCI Canada Index Fund (NYSEARCA:EWC) allocates only about 19% of its holdings to materials, giving the largest weighting to financials (this sector accounts for about 34% of EWC and just 7% of CNDA). EWC has an average market cap of about $28 billion, compared to just $1.7 billion for CNDA.

Disclosure: No positions at time of writing.