Middle East Gulf States Index ETF Fails to Capture Geographic Opportunity

| About: VanEck Vectors (MES)

Investing in the Gulf states (think the Middle East - not the BP spill) certainly makes sense as the region has some of the fastest growing economies in the world. This growth is being driven by crude oil and natural gas reserves that are financing an unprecedented infrastructure build. The region now has first world infrastructure with third world labour rates, a powerful combination. Add to this its strategic logistical position and it is not hard to see why the non-oil sector is growing dramatically. The region is also attractive from a valuation perspective, having dramatically lagged BRIC countries in 2010.

The Gulf States Index ETF (NYSEARCA:MES) seeks to capture this opportunity by replicating, before fees and expenses, the performance of the Dow Jones GCC Titans index. The ETF is certainly 'interesting' in as much as it actually out-performed its index on a YTD basis, increasing NAV by 1.84% against a 0.92% rise in the index as at 31st March, 2010. Only thing is, ETF's are not designed to out-perform so one has to assume its construction methodology is not as tight as one would like.

The net expense ratio is only 0.99%. This is fine, until one reads the small print. The expenses of the fund are capped contractually at 0.98% (the difference being interest expenses which are not part of the cap). This cap disappears on 5/1/2001. If one calculated a Gross Expenses Ratio on the current assets it would be a staggering 4.64%.

The Gulf is a deep market and yet the Dow Jones GCC Titan index has only 40 stocks. The stock concentration is therefore extremely high in this fund. Zain, a Kuwaiti telecom company, is the largest holding, some 8.09% of the fund. The second and third holdings are also Kuwaiti, representing 7.84% and 7.61% respectively. 23.53% of the fund is therefore concentrated in just three names in a small country that represents just 0.66% of the geographic area of the Gulf states.

More worrying for investors in the regional growth story than the Kuwait exposure is the total lack of exposure to Saudi Arabia. The Kingdom represents over 80 percent of the area of the Gulf states. MES has zero exposure. The reason for this is simple. Foreign investors can not get direct exposure to investment in Saudi Arabia and therefore the Kingdom is not included in stock indexes by default. This shows why it is so dangerous to take an indexed approach to frontier markets. Active funds can and do get exposure to Saudi Arabia via Swaps and Participating Certificates on the underlying equity.

In conclusion, this is an expensive, poorly constructed, undiversified and inappropriately benchmarked ETF. In my opinion, MES is best avoided.

Disclosure: No positions