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The Globe and Mail

For foreign ETFs, time to think outside the basket

The economic prospects of Vietnam and Poland look good to Tyler Mordy, president and co-chief investment officer of Hahn Investment Stewards & Co. Inc.

Jeff Bassett/The Globe and Mail

Shifting growth patterns around the world may require investors to become more selective when they shop for international exchange traded funds to diversify their portfolios.

The days of gaining appropriate exposure by purchasing one broad ETF, with holdings from Guatemala to Guam, may be over. Increasingly, advisers are telling clients to be more selective and to weigh diverging factors such as valuations, fundamentals and government policies.

It's never been easier for people outside the investment industry to buy into international stock markets. Consumers can purchase a single ETF, with dirt-cheap fees, comprised of stocks that cover the globe. Without any further effort, they can sit back and reap the gains of global economic growth – such as it is today.

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For example, this summer Vanguard Investments Canada Inc. introduced the Vanguard FTSE All-World ex-Canada Index ETF (VXC), which gives exposure to 2,900 stocks in 44 countries beyond Canada. One purchase and you're done. This is candy for the lazy investor; it trades in Canadian dollars on the Toronto Stock Exchange and carries a management fee of only 0.25 per cent.

But as the ETF industry has grown more popular and more sophisticated, buying foreign exposure is no longer so simple, especially in developing economies, money managers say.

"The era of buying a broad-based emerging markets ETFs is over," said Tyler Mordy, president and co-chief investment officer of Hahn Investment Stewards & Co. Inc. in Toronto.

He sees two reasons for the shift. First, investors have tended to equate GDP growth with stock market returns, but that is not always the case. In reality there is frequently a negative correlation between the two, because people overpay for "headline" growth, or sectors that are making news. Finding better valuations will be key to producing better returns, Mr. Mordy said.

Second, broad-based equity ETFs, especially emerging-market funds, are dominated by yesterday's winners, he said. China's hyper-growth phase between 2002 and 2011 created an insatiable demand for raw materials and lifted the fortunes of resource-heavy countries. Now that China is stabilizing, wise investors are moving away from commodity exporters to commodity importers, he said.

This trend favours countries such as China or India over Russia or Brazil. For India, energy and other "input costs" have tumbled, the balance of payments has improved and domestic consumption is rising. In Russia, capital is leaving, prices are rising and domestic consumption is declining, he said.

Mr. Mordy also likes the prospects of Vietnam, where cheap labour has made the country the outsourcing hub for most of Asia, as well as Poland, where labour costs are on par with China and the currency is cheap.

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"The major trend in the global economy is one of growing divergence, rather than decelerating growth," said Russ Koesterich, chief investment strategist at New York-based BlackRock Inc., the world's largest asset manager.

"Global economic growth over all appears stable. However, there is a noticeable increasing divergence in growth among different regions and countries, meaning investors should be more worried about certain markets than others," he said in his monthly market commentary.

U.S. stocks are expensive today while domestic spending and income face slow growth. That combination suggests returns for the U.S. market will be modest and better opportunities lie abroad, Mr. Koesterich said. He favours Japan, where stocks are cheaper than any other developed country.

"We expect Japanese stocks to outperform over the next six months given attractive relative valuations, likely upward revisions to corporate earnings, and the possibility that pension funds will raise their domestic equity allocations. Meanwhile, the government's structural reforms continue to steadily progress, with notable improvement in corporate governance that is helping to increase Japan's return on equity," he writes.

Mr. Koesterich is also overweight Chinese stocks, which he says are trading at a deep discount to developed markets and the broader emerging market ETFs.

"Some of this discount is justified given concerns over the local banking sector, property market and corporate governance," he wrote. "But investors appear to be discounting a greater economic slowdown than is likely."

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BlackRock recently reported that its iShares ETF business had net inflows of $18.2-billion during the third quarter, driven by demand for equities, especially in Asian and emerging markets.

An investor who bought an ETF at the start of this year tracking the broadest global equity benchmark, the MSCI World Index, would have recorded a gain of about 3.5 per cent.

In comparison, an investment in an ETF tracking the FTSE China 50 Index would have returned 3 per cent, and a stake in an ETF mirroring India's market through the CNX Nifty Index would have delivered a 31-per-cent gain.

These types of single-country ETF products are now available to Canadians on the TSX, qualifying them for registered accounts and limiting currency risk. Providers include BlackRock's iShares, Invesco Canada Ltd.'s PowerShares, Vanguard Investments Canada and the Bank of Montreal.

Some international portfolio managers at mutual fund companies warn that buying a passively managed ETF that tracks an emerging market benchmark will give an investor significant exposure to state-run enterprises, such as China Mobile Ltd., PetroChina Co. Ltd. or State Bank of India. These government-owned businesses still dominate industries in developing markets and often have different goals than their investors.

Mr. Mordy, however, says that state-run enterprises are gradually being dismantled as part of capital reforms in China and elsewhere.

"There are not good assets and bad assets. There are only good prices and bad prices. In the case of state owned enterprises, they are really, really, really cheap," he said.

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