EPP: Capturing Emerging Market Gains Without All the Risk

Oct.23.07 | About: iShares MSCI (EPP)

Unlike many Pacific ex-Japan funds, which spread their stocks broadly across countries in the region and tend to focus on developing markets, iShares MSCI Pacific Ex-Japan (NYSEARCA:EPP) invests in just four countries, all of them with fully developed economies.

That doesn’t mean the fund hasn’t tapped into some of the extraordinary gains in emerging markets, because stocks based in Australia and Hong Kong — which recently accounted for more than 86% of EPP assets (the fund makes smaller bets on stocks from Singapore and New Zealand) — have benefited mightily from a close relationship with China’s exploding economy and other high-powered stories in Asia. Both countries’ benchmark indices hit record highs last week.

EPP gained 15.9% over the last month (through Oct. 12) and 40.2% year to date and climbed four spots on the International Momentum Table over the past five weeks, reaching the No. 7 spot last week.

Resource-rich Australia helps feed China’s insatiable appetite for raw materials, the reason many investors see to invest in the Land Down Under. But markets in Australia and Hong Kong have a heavy emphasis on financial stocks, which recently made up nearly 50% of EPP’s portfolio.

Aussie banks and financials, which helped drag the Australian benchmark S&P/ASX 200 index down 10% in the 19 days through Aug. 16, reversed that trend quickly, as the index surged 15% from that 2007 low, through Oct. 11. The country’s bank stocks have been relatively untouched by the credit crunch.

That, combined with firm metal prices and 16 straight years of economic growth, helped lift the S&P/ASX 200 Index to a string of all-time highs that peaked again on Monday. The index is up 19% year to date and 23% over the last two months.

Meanwhile, Hong Kong’s benchmark Hang Seng Index is up 44% this year, almost all the gains coming since August, when the Chinese government said some of its citizens, with estimated savings of $5 trillion, would be allowed to invest in Hong Kong shares. Estimates of the coming inflow to Hong Kong equities in the next year start at $60 billion and go much higher.

EPP’s top 10 holdings, which account for about 35% of its total holdings, include two materials stocks; six financial names; and the world’s largest shopping mall owner, Westfield Group (whose shares are up 16.8% since Aug. 16, partly on news of a European expansion).

The fund’s gains have been split among the power of those financials and resources shares. Gold, up 18% year to date, reached 27-year highs last week, on sentiment that a weaker dollar and record-high crude- oil prices would push more investors toward gold as a hedge against inflation.

Copper, nickel, lead and other metals also rose, with UBS raising its forecasts for seven different metals last week. BHP Billiton, the fund’s top holding, has seen shares rise 113% year to date and 28.5% in the last month. Shares of two other EPP holdings, Newcrest Mining and Lihir Gold, gained more than 30% in the last month, on takeover speculation. Shares of No. 9 holding Rio Tinto are up 84% year to date.

A few notes of caution: With many analysts concerned about a Chinese bubble, some see the markets in both Australia and Hong Kong as overvalued. Last week, Aussie financial stocks dropped, on concerns, according to Bloomberg, “that they have rallied too far, too fast in the last eight weeks.”

Though UBS raised metal forecasts, it also downgraded the global mining sector to neutral, on concerns that mining prices are already factoring in expected price increases.

As for Hong Kong, those Chinese policy changes were delayed on Sept. 5 and remain in limbo. Meanwhile, BusinessWeek reported this week that the Hong Kong Exchange (run by EPP’s No. 7 holding) may integrate with one or both of China’s main markets. The implications of such a move are unknown, but some worry that Hong Kong’s reputation for regulatory integrity could be compromised, BusinessWeek said.

So far so good, though, for EPP: the fund’s five- year annualized return of 32.7% is nearly nine percentage points better than that of the MSCI EAFE Index. That could be expected, given the run-up of materials and Australian stocks. Almost since its 2001 inception, EPP has had the wind at its back.

Still, the fund should lag its category when emerging-market stocks surge. And it did, in 2005 and 2006. The difference hasn’t been great (0.02% in ’05, 5.9% in ’06). The fund’s bulls point to its indirect exposure to China’s growth as a way to cash in on emerging- market growth without all the risk, as evidenced by the fund’s three-year standard deviation of 13.63, low for the category.