Country Selection: ETFs vs. Individual Stocks

by: Roger Nusbaum

IndexUniverse posted an interview with a portfolio manager who only uses country funds to build client portfolios. On one hand, it was an interesting interview; but on the other hand, I'm not quite sure what to make of it. First let me say that anyone can have success with any strategy so this is not meant to be critical of this one approach; rather, it meant to figure out what we might be able to learn.

I place a lot of emphasis on country selection, and also country avoidance, so I am on board with this part of it: Country selection for outperformance and effective diversification. For a little background, I've mentioned quite a few times how important both country selection and sector selection (more like sector avoidance) were over the last ten years, but that going forward I don't think sector selection will be as important as country selection.

What made sector selection so important was that two sectors grew too big (tech to 30% of the SPX and then, more recently, financials to greater than 20%); a sector greater than 20% is like a yellow flashing light, and above 30% is like a tsunami siren. My hunch is that it will be a while before another sector gets that large after happening twice so close together, but if it happens, then that sector will be an underweight.

On the flip side, I do think country selection will again be very important in this decade. I've referred dozens of times to Bespoke Investment Group data that show many markets around the world having normal or better than normal decades during the 2000s as the SPX was falling 24% on a price basis.

In the IU article, the portfolio manager has a process for winnowing down the list of possible countries, with one screen filtering that there is an ETF for that country. Here the strategy is a little lost, as in the name of not taking single stock risk, they only use ETFs. I would suggest using whatever you think is the best proxy, not defaulting to the country fund. Back in 2007, I was on a panel at an ETF conference and one of my co-panelists asked me why I prefer Volvo (OTCPK:VOLVY) to the iShares Sweden (NYSEARCA:EWD); this anecdote is a repeat. I've been favorably disposed to Sweden as an investment destination for years and we still own Volvo.

The reason to prefer Volvo over EWD is that the ETF has always been heavy in Ericsson (NASDAQ:ERIC), which is a company I want no part of. Deciding that you don't want a stock takes a lot less time than selecting one to buy. Volvo has generally outperformed the ETF at every turn, but I would note that Volvo went down more than EWD during the crisis, which strikes me as normal for a heavy industrial stock. While I have not crunched the numbers, I believe that the outperfomance is primarily attributable to the large weighting of ERIC in the ETF.

This has also been true with our position in Vale (NYSE:VALE) vs. iShares Brazil (NYSEARCA:EWZ). Obviously not every stock pick will outperform the corresponding country fund, and in several instances that isn't necessarily the objective, but some of the country funds are heavily weighted in stinkers (i.e. EWD with ERIC). This is reason enough to seek another way in and, zooming out a little bit, circles back to the idea that it makes no sense that any single wrapper can be the best way in for all exposure at all times.

One thing not addressed in the article is whether narrower country funds can be used. For example, there are small cap funds for Taiwan, Australia, Korea and Canada from IndexIQ. EG Shares has a small cap fund and infrastructure fund for India and plenty of providers have a small cap Japan fund. Another provider, maybe Global X, filed for a bunch more small cap country funds. Obviously Global X has sector funds for China and Brazil. What about them?

In previous posts, I've mentioned that I'm looking at getting back into South Africa. There is one stock I like but the volume might be a little light. In thinking about ETFs, there is, of course, the iShares South Africa (NYSEARCA:EZA), but perhaps the First Trust Platinum ETF (NASDAQ:PLTM) would be better (that fund is 33% South Africa), or one of the miners directly? Even if the one stock I am most interested in doesn't have enough volume, there are other names with the necessary volume that are also very solid companies.

This sort of sifting process makes much more sense than limiting your investments to one type of wrapper, but maybe you see it differently? Perhaps the portfolio manager quoted above would say that if a country fund is too heavy in a stinker stock he would avoid the fund, but does that mean he would then have to avoid a country that otherwise screened well? I tend to think the country exposure is more important than the wrapper.

ETFs clearly democratize this sort of thing and using a lot of ETFs is certainly valid, but exclusive use is far less valid.