Using Trade-To-GDP Ratio To Evaluate Country ETFs

by: Richard Shaw

If you are considering investing in single country funds, you should learn about the country in a fundamental way, not just by reviewing fund performance and portfolio statistics.

Just as you would research the fundamentals and the character of any company in which you invest. In general, it's important to know about countries in which you invest.

One of the many fundamental facts about a country that investors should understand is the significance of international trade to the economy.

One indicator of the significance is the “trade-to-GDP ratio” which is the sum of exports and imports divided by the gross domestic product.

There is no specific cause and effect relationship between this ratio and the economic health of a country or funds that invest in the country, but it is an attribute of a country you should understand if you intend to invest in country specific funds.

The chart below shows the Trade-to-GDP ratio for 30 countries for which country specific investment funds are available in the U.S.

The spread is tremendous, with several countries generating trade less than 50% of their GDP (U.S.A, Japan, Brazil, India and Australia), and several countries generating trade more than 100% of their GDP (Singapore, Hong Kong, Malaysia, Belgium, Thailand, Netherlands, Taiwan and Austria).

For politically sensitive readers, we understand that Hong Kong is part of China and that China claims Taiwan as part of itself (and that the World Trade Organization calls Taiwan, the “Taipei Chinese”), but from an investment perspective, certainly Taiwan and probably Hong Kong can be treated as separate countries.

There are, of course, many more facts to consider than just the Trade-to-GDP ratio. However, but it is probably safe to say that countries with a high ratio (such as Singapore) are more economically sensitive to changes in the level of global trade than countries with a low ratio (such as Japan).

Not only do you need to understand the relative importance of international trade to a country’s economy, but you should delve beyond those numbers to find out who each country’s trading partners are.

For example, you might want to know that while China is Taiwan’s primary export market, the United States is Thailand’s primary export market, and Japan is the primary export market for Indonesia; or that Europe is a more important export market for Brazil than the United States, or that the United Arab Emirates is the third most important export market for each of the United Kingdom and India.

The currency of a country is more likely to be sensitive to changes in national economy than the equity index for the country. Currency could be analogized as the “stock” OF a country, whereas the equity index is a group of leading stocks IN the country.

That difference is important to keep in mind. Even emerging market countries today have global giants within their equity indices (such as Gazprom in Russia, or Wipro in India). The return on those stocks may be geared more to overall global trade than to national trade statistics for their domiciliary country.

The table below presents the data for the Trade-to-GDP chart along with one or two proxy investment funds for each country.

We did not include mutual funds, although there is nothing wrong with them, so long as they don’t charge front loads, redemption fees or excessive management fees. In some cases, there are more than two funds available, in which case we listed the two with the largest asset base.

The 43 funds named are not recommendations. They are representative only and do not necessarily present an inclusive list.

You need to interpret the trade data carefully. For example, does India have a low Trade-to-GDP ratio because its domestic economy is large or because its global trade is not fully developed? What would be the impact on the trade pattern, and therefore on the country’s economy, in the event of a war in their region or in the region of one of their major export or import trade partners? Questions such as these are important to help you chose a diverse group of countries with a minimum of vulnerability to a common event or situation. The world is interdependent making it impossible to avoid overlap of vulnerabilities and risk exposures, but it is possible to reduce exposure to common risks through rigorous analysis.

The Trade-to-GDP ratio also does not tell you much about the balance of export and import trade, or whether the trade is in the form of merchandise or commercial services.

Merchandise is customs-based data and refers of agricultural products, fuels, mining products and manufactured products.

Commercial Services refer to communication, construction, insurance, financial, computer, information, other business, and cultural and recreational services, and royalties and license fees.

If you wish to actively manage your country exposures, our general recommendation is to invest 50% to 80% in a core allocation of broad-based multi-country funds. Then, we would suggest investing the balance in a selection of individual country funds that will overweight your exposure to countries that you believe represent better opportunity than the broad-based index.

We think this is a conservative and prudent approach for active management for most people. It should produce less volatile and more rewarding results over the long-term than attempting to bet on a narrow spectrum of countries and your ability to predict their return.

It is possible to make useful predictions about the future of securities, but it is not possible to do so perfectly nor for most people consistently over time.

There is cause and effect at work in markets. Research and logic do add value to investment decisions. However, there is also an element of randomness to world events that cannot be predicted. For example, some events such as unexpected war or terrorism can turn the tables in a moment on a well reasoned investment decision. As a result a portfolio of undiversified country investments is not a good idea for most investors.

For these reasons, we recommend that broad index funds (such as thoses based on MSCI EAFE, or MSCI emerging markets, or FTSE All World excluding U.S.) be an important part of most portfolios invested internationally.

We have done further research that shows the world market share of each country for merchandise exports and imports, and for commercial services exports and imports.

A few highlight facts are these:

  • Six countries have net positive trade balance in both merchandise and commercial services (Austria is our favorite)
  • Germany is the largest gross exporter of merchandise, and the largest net exporter (exports minus imports) of merchandise
  • The United States is the largest gross exporter of commercial services, and the largest net exporter (exports minus imports) of commercial services
  • Germany has the worst net commercial services balance of trade
  • The United States has the worst net merchandise balance of trade

The 30 countries in the list above generate about 80% of the world’s merchandise and commercial services trade, with a near zero net trade balance. That means the other approximately 130 countries in the world generate only about 20% of world trade.