iShares MSCI All Country Asia Ex-Japan Is Too Heavily Tied To China's Success

Sep.13.11 | About: iShares MSCI (AAXJ)

By Paul Justice

Want to get in on the Asian growth story, minus stodgy, slow-growing Japan? IShares MSCI All Country Asia ex Japan (NASDAQ:AAXJ) is it. But keep in mind that fast-growing economies have in the past been disappointing investments. Markets do a pretty good job of compounding growth expectations into current prices and, in fact, tend to overshoot on the upside. This fund is only a screaming buy if you think the market's growth expectations are too low. And even if Asia smashes growth expectations on the upside, there's no guarantee that those earnings will trickle down to you, the foreign minority shareholder. Your stake may get diluted away, bad managers might throw capital at bad investments, or political, macroeconomic, and social instability may sink the market.

We wouldn't recommend this exchange-traded fund as more than a moderate portion of your overall equity portfolio. It's a bit pricey, fast growth tends to end in tears, and it's highly exposed to China's fortunes despite only a 20% weight to the country. To elaborate on the last point, many seemingly disparate asset classes are more connected to Chinese monetary and fiscal policy than you'd think. China's been on an investment binge for a few decades now, but China really went wild a few years ago to ward off collapsing global demand. As a consequence, commodity prices have risen, China's in a credit boom, and many Asian countries have enjoyed spillover demand from their giant neighbor. If you hold lots of commodity exposure, whether through firms, exporters, or futures, this fund will further concentrate your portfolio.

This fund's high expense ratio and liquidity make it more suitable as a trader's vehicle than a buy-and-holder's. Cheaper options exist, but they aren't as liquid.

Fundamental View
Asia has growth, and lots of it. Much of the credit goes to China, the 800-pound gorilla. Its economy has grown at a breakneck 10% annualized since Deng Xiaoping began capitalist reforms in the early '80s. Maybe you're kicking yourself for failing to get in on this amazing opportunity earlier. Don't feel too sorry for yourself. China's stock market has yet to break even since the start of 1993 (the MSCI China Index's inception). While the Chinese economy was booming in the '90s, the MSCI China Index lost 88% before rebounding in the past decade. What happened? Earnings didn't collapse. Investors lost out because new enterprises sprouted up, and old companies issued new shares. This dilution cost investors 32.5% annualized in returns from 1992-2003, according to one study. For this reason, investors can't expect Asian stocks' per-share earnings to track GDP growth over the long haul. By my calculations, emerging-markets' total-return dilution has averaged about 7% annualized from 2007-11.

The Chinese story isn't a fluke. Historically, booming economies often don't turn out to be excellent stock markets, with almost no correlation between them during the 20th century. With those warnings aside, let's dive into why Asia's economy has been thriving and what the risks are.

The Communist Party has staked its legitimacy on growing the economy at least 8% annually--any lower and it believes it risks serious social unrest. The fixation on GDP growth is so pervasive that officials are promoted based on it, skewing incentives to grow GDP at any cost. The party has kept growth high by subsidizing a credit-driven infrastructure boom, easily achieved thanks to China's incredible 40% savings rate. The boom has raised commodity prices worldwide and, thanks to spillover demand, lifted neighboring economies, which are increasingly trading with China over the West.

With so many countries' prospects tied to China's, the main risks to Asia stem from the quality of China's investments. Fixed investments are half of China's GDP, and some researchers estimate that China's gross debt/GDP ratio is more than 80%. Prominent economists like Nouriel Roubini have questioned whether a country can productively invest that much money that quickly, especially when political calculus is driving capital allocation. Bad debt has sunk emerging markets in the past. However, China's $3 trillion-plus foreign exchange reserves offer a lot of cushion. We aren't terribly worried about the medium-term future.

The bottom line is that this ETF is highly concentrated on the fortunes of a single credit-bloated country and that investors shouldn't expect high GDP growth to crystallize as fabulous stock market growth.

Portfolio Construction
The ETF tracks the MSCI All Country Asia ex-Japan Index, which replicates the free-float-adjusted market-cap-weighted performance of 10 Asian countries, emerging and developed. As the name implies, it excludes Japanese stocks. The five countries with the biggest weights are China, South Korea, Taiwan, India, and Hong Kong, which together make up about 80% of the index. The fund samples its index, so expect some tracking error. Finally, the fund may have a tiny bit of counterparty risk from its securities lending.

The fund charges 0.69% per year, on the high end for broad emerging-markets ETFs. IShares lends out shares and distributes most of the income to fund investors, cutting a few basis points from total expenses. The fund's passive, total-market construction keeps turnover costs down.

Aside from excluding South Korean companies, SPDR S&P Emerging Asia Pacific (NYSEARCA:GMF) looks a lot like AAXJ. Indeed, since inception, it has moved in lock step with AAXJ. It's cheaper at 0.59%, but its smaller size may leave it less liquid, eliminating the cost advantage for frequent traders.

Investors seeking further diversification should look at Vanguard MSCI Emerging Markets ETF (NYSEARCA:VWO), which tracks the MSCI Emerging Markets Index. It covers 21 emerging-markets countries and costs a mere 0.22%.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.