Morningstar Advisor - December/January 2012 - (Page 71)

Sortino ratios greater than 0.4—again, as a point of reference, the Sortino ratio for the MSCI EAFE Index and MSCI ACWI ex-US was 0.09 and 0.14, respectively. This screen generated a list of 18 ETFs on Nov. 8; we highlight our picks of the group below. IShares MSCI Pacific ex-Japan EPP WisdomTree Asia Pacific ex-Japan AXJL The easiest way to avoid Europe is to invest in an Asia-focused fund. IShares MSCI Pacific ex-Japan EPP invests only in developed Asian countries, which includes Australia (which accounts for 64% of the fund’s portfolio), Hong Kong (20%), and Singapore (13%), countries with well-developed capital markets and rule of law. Many of the holdings in this fund do business with or are invested in China and other emerging Asian nations, so investors considering this fund should have a long term positive outlook on the region. But investors can also consider this fund for its diversification benefits. Relative to broad international funds, the fund has a relatively lower correlation to U.S. equities, as most of the large caps in this fund don’t compete with the large cap multinational financial, consumer, energy, and health-care firms from the U.S. and Europe. This ETF also has a heavy 20% exposure to the materials sector, typically underrepresented in broad U.S. equity funds. A risk to consider before jumping into this fund is the 19% weighting in Hong Kong and Singapore financial firms. Many of these firms are property-development companies with heavy exposure to real estate in China, where prices in certain cities are approaching bubble levels. Investors should also note this fund’s exposure to the Australian dollar through this fund’s Australian holdings. The Australian dollar is considered a commodity currency, whose exchange rate can fluctuate strongly during periods of market volatility. At 4.6%, the fund’s yield is attractive, and its expense ratio of 0.5% is reasonable for an international fund. This ETF has a similar theme, investing across developed and emerging Asian countries (excluding Japan), but its holdings are dominated by Australian (26% of the portfolio) and Hong Kong companies (19%). Another difference between this fund and the iShares fund is that the iShares fund is a market-capweighted fund, while AXJL takes the 300 largest companies from the Asian region and weights each constituent by annual cash dividends paid. We like the dividend-weighting methodology, which is a straightforward measure of value that is not affected by variances in accounting standards across countries. We also think that dividends can be a sign of good management and corporate stewardship. Relative to the iShares fund, this ETF has a slightly higher dividend yield of 4.9% and a slightly lower expense ratio of 0.48%. WisdomTree Intl. SmallCap Dividend DLS future. This ETF’s yield is 4.2% and its expense ratio of 0.58% is in line with international small-cap funds. First Trust DJ Global Select Dividend FGD This developed-markets fund also invests in the United States. The ETF weighs its components by dividend yield, but it first screens for dividend quality to avoid stocks that may be paying an unsustainably high dividend. The fund has a large 19% exposure to the financial sector but a low exposure to European banks. The 5.1% yield is attractive, and its expense ratio is 0.6%, which is a little high given its exposure to very liquid securities. WisdomTree Emerging Markets Small Cap Dividend DGS This small-cap, developed-markets fund has a relatively low 38% exposure to European securities. Like WisdomTree’s Asia Pacific fund, WisdomTree International SmallCap Dividend weighs its constituents based on annual cash dividends paid. Generally, we like small-cap international stocks for two reasons: lower correlations to U.S. stocks relative to international large caps, and the small-cap premium, which is the tendency for small-cap stocks to outperform large caps over long periods. Small-cap stocks tend to cater to domestic markets, and over the past 10 years, the correlation between the MSCI EAFE Small Cap Index and the S&P 500 was 80%, lower than the 90% correlation between the MSCI EAFE Index and the S&P 500. The risk for this fund is its large exposure to Japanese stocks (37% of the portfolio). Historically, this large exposure to Japan equities has helped reduce volatility, and the appreciation of the yen against the dollar was the main source of returns for the Japanese equities allocation during the past decade. A slowdown in the yen’s appreciation and continued underperformance of Japanese equities could negatively affect DLS in the Despite its name, DGS is actually not a very risky fund. Because emerging-markets small-cap companies tend to be fairly established, the volatility of a portfolio of small-cap emerging-markets stocks has been in line with that of a broad-market portfolio of emerging-markets stocks. In addition, many emerging-markets large-cap stocks are partially government-owned, and at times, these entities put political goals ahead of profitability, which can weigh on share prices. As a small-cap fund, DGS doesn’t have these types of companies in its portfolio and instead holds mostly market-oriented firms. Since inception, the fund has traded at slightly lower P/E ratios and delivered better risk-adjusted returns relative to a market-capweighted small-cap emerging-markets index, but we note that the fund has had a short track record. Most notably, its three-year standard deviation of 29.5% was significantly lower than the market-cap-weighted MSCI Emerging Markets Small Cap Index’s 35.3%. This may suggest that dividend-paying emerging-markets companies are higherquality firms. DGS sports a yield of 4.4% and has an expense ratio of 0.63%. Patricia Oey is an ETF analyst with Morningstar. MorningstarAdvisor.com 71 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - December/January 2012

Morningstar Advisor - December/January 2012
Contents
Contributors
Letter From the Editor
Seduced by Complexity
Is China Exposure Important for a Portfolio?
A Niche Built on Trust
How to Find Your Client’s Investment Style
Taking the Long View
Consensus on Europe Elusive
Four Picks for the Present
Investment Briefs
Is Perception Reality for Active Managers?
Be Alert for Basic-Materials Bargains
Investment Boom Unsustainable
Digging Moats in China
Where China’s Domestic Companies Stand to Benefit
Arising Opportunities
China Strong Long Term
From Currency Manipulation to International Acceptance
The Keys to China’s Fortune
Wedgewood’s Lessons Pay Off
Reading the Evidence on Indexing
Scouting for Investments Abroad
Yield, Please (Hold the Europe)
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
China Fund Managers Eat Elsewhere

Morningstar Advisor - December/January 2012