Adding Some Gangnam Style To Your Portfolio

| About: iShares MSCI (EWY)

By Patricia Oey

The South Korean market may be described as having somewhat of a split personality. South Korea is still considered an emerging market by index provider MSCI but is classified as a developed market by its close competitors in the index arena, FTSE and S&P. Many South Korea firms are export-oriented, with customers in both the emerging and developed markets. So it is not surprising that the South Korean market can sometimes march to its own beat.

In the second half of 2013, South Korean stocks rallied on an improving macroeconomic outlook in the U.S. and Europe and significantly outperformed many emerging-markets peers. However, both iShares MSCI South Korea Capped (NYSEARCA:EWY) and the MSCI Emerging Markets Index have stumbled out of the gate in 2014; both have declined about 8% on a year-to-date basis.

While these markets' shared short-term struggles may seem to suggest that the South Korean market is suffering from the emerging-markets blues--brought on by tapering by the U.S. Federal Reserve and slowing growth in China--this fund's recent weak performance might actually be more related to selling pressure on its largest holding, Samsung Electronics. Samsung (OTC:SSNLF), which accounts for about 20% of this fund's assets, currently holds the number-one position in the global smartphone market, and mobile telephony accounts for about 60% of the firm's operating profit. Samsung is starting to see its mobile phone sales mix tilt away from higher-margin smartphones toward lower-margin mid- to lower-end phones, driven by strong demand for lower-end phones in emerging markets and slowing global growth for high-end phones. However, as of the time of writing, downside for this stock might be limited. Currently low valuations reflect the more challenging near-term outlook. In addition, investors have been pressuring Samsung to return some of its $50-plus billion cash pile to shareholders, and in the past four months, the firm has announced two increases to its dividend. Samsung's shares currently sport a dividend yield of about 1% (still low relative to Apple's (NASDAQ:AAPL) 2%).

As for EWY's other holdings, the exporters among them may start to see competitive pressures ebb--whereas in 2013, South Korean electronics, machinery, and automakers had to deal with a tough competitive environment as Japanese peers benefited from a rapidly declining yen. So far this year, the yen appears to have stabilized, and a healthier outlook in the U.S. and Europe should also benefit South Korean exporters.

Fundamental View
Large-cap South Korean firms have demonstrated their might over the past decade. Many companies, such as Samsung Electronics, Hyundai, and LG have successfully moved up the value chain, increased market share, and now have well-established, globally recognized brand names. In the coming years, we expect South Korean corporates to benefit from free trade agreements with the European Union and the United States, which were signed in 2011. South Korea also has strong economic ties to China--exports to China account for a fourth of its total exports. We expect economic development in China, as well as in other emerging markets, to be an important driver of growth for many of South Korea's larger companies over the medium term.

However, on the domestic-demand front, Korean consumers have the highest levels of consumer debt among OECD nations, and property prices have been softening. These issues are negatively impacting consumer sentiment and spending. Corporate South Korea has also been slow to invest over the last few years, given the weak global growth environment.

South Korean equities trade at a lower price/earnings ratio relative to fellow export-oriented peer Taiwan and oftentimes even trade at a lower multiple than the MSCI Emerging Markets Index. While some cite the lingering threat of a confrontation with North Korea as the reason for the "Korea discount," most experts point to corporate governance issues. Many of South Korea's large-cap firms are part of family-run conglomerates called chaebols. Chaebols have a legacy of complicated cross-holdings, supporting unprofitable subsidiaries, and murky related-party transactions. And like Samsung, these firms also prefer to maintain large cash balances. These issues partially explain why South Korean companies typically have relatively lower dividend yields. In 2011, South Korean companies were forced to adopt new accounting standards, which require quarterly reporting at the consolidated level, versus only at the parent level in the past. This improved transparency may help to reduce the Korea discount in the coming years.

iShares MSCI South Korea provides broad exposure to the South Korean equity market, which has a cyclical orientation, given its heavy exposure to technology, consumer discretionary, and industrial firms, many of which are large exporters.

Because of this cyclical tilt, South Korean equities as a group are among the most volatile in the Asian region. This fund's trailing 10-year standard deviation of 28.6% is higher than the MSCI Emerging Markets Index's 24.0%. Its annualized trailing three-year beta versus the S&P 500 is also high, at 1.3. This fund is also very concentrated--top holding Samsung Electronics accounts for around 20% of fund assets, and the top-10 holdings collectively account for about 50%.

As a single-country fund, EWY is suitable as a satellite holding. Investors can use this fund to manage their exposure to the South Korean equity market. At the moment, both FTSE and S&P classify South Korea as a developed market. MSCI still categorizes it as an emerging market, but it will be up for review in June 2014. For investors using a broad cap-weighted index fund for their emerging-markets stock allocation, their exposure to South Korean stocks will depend on which benchmark their fund tracks. Also, South Korean firms tend to be relatively low dividend payers, and therefore have low representation in international equity dividend funds. Investors should check their exposure to South Korean equities before investing in this fund.

Portfolio Construction
This fund tracks a float-adjusted, capitalization-weighted index that aims to capture 85% of the publicly available market capitalization of South Korean stocks. On Feb. 11, 2013, this ETF changed its index from the MSCI Korea Index to the MSCI Korea 25/50 Index. MSCI's 25/50 Indexes are designed to take into account U.S. IRS investment constraints needed for a fund to qualify as a Regulated Investment Company. This change was necessary as Samsung Electronics' allocation within EWY continues to edge closer to 25%, thanks to its recent outperformance. To be RIC compliant, funds cannot have any holdings that exceed 25% of assets, and the sum of all issuers whose weighting is above 5% cannot exceed 50%. If the fund did not change its index, it could incur tracking error in the case that these IRS-mandated thresholds were breached. This fund does not hedge its foreign-currency exposure.

This ETF's expense ratio is 0.62%. The goal of an index fund is to provide the returns of the index, less fees. Over the past five years, the fund has trailed its index by 59 basis points, close to its expense ratio, which implies that the fund is tracking its index well.

EWY is the only ETF to provide broad exposure to Korean equities.

An actively managed open-end option is Matthews Korea Investor (MAKOX). Relative to EWY, this fund has less exposure to the global cyclical sector such as industrials and technology and has an overweighting in consumer names. While it has more of a mid-cap tilt, MAKOX's volatility is lower than that of EWY. This fund would be more suitable for investors looking for exposure to domestic-growth trends, whereas EWY would be better for those looking for a fund to play a global recovery. The Matthews fund has slightly outperformed EWY over the trailing 10 years, and this outperformance gap has increased significantly in the last three years. MAKOX charges 1.21%.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

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