7. Single-Country Equity Exchange-Traded Funds

The funds in question may also be concentrated in other respects—e.g., by sector or company. The issue will be further discussed later in the chapter.

Numerous other variations of these indicators are also applied in the investment practice. However, due to the limited scope of the book, they will not be discussed.

All the more, no particular importance should be attached to the place of listing. In the case of some ETFs (e.g., Israeli), they invest in shares listed on various stock exchanges, especially the American ones.

According to Capital Group research, the 10 largest companies in Europe (Nestlé, Royal Dutch Shell, Novartis, Roche, HSBC, BP, Total SAP, AstraZeneca, and LVHM) generate on average only 30% of their revenue from their home region. The rest derives from emerging markets (31%), North America (29%), and Asia-Pacific region (10%) (Lovelace and Polak 2019).

The S&P Dow Jones Indices study of the US equity market demonstrates that these indicators, despite some fluctuations, have been at a similar level for years. In 2018, the percentage of S&P 500 sales from foreign countries was 42.90%, down from 2017s 43.62%, and 2016s 43.16%. The recent high mark was 2014s 47.82%, and the recent low mark was 2003s 41.84%. Asia, Europe, UK, Japan, Africa, and Canada accounted for 8.24, 8.24, 1.49, 1.14, 3.82, and 1.98% of all S&P 500 sales, respectively (Silverblatt 2019).

Regardless of the market, companies’ geographic sources of revenues matter most in the aftermath of surprising political or macroeconomic events such as the USA’ November 2016 presidential election and the UK’s June 2016 vote to leave the European Union.

For example, percent of revenues derived from outside USA is about two times higher in the S&P 500 Index than in the Russell 2000 Index, 20 percentage points higher in the FTSE 100 Index than in the FTSE 250 Ex-Investment Trust Index, and about 10 percentage points higher in the S&P/ASX 200 Index than in the S&P/ASX Small Ordinaries Index.

These conclusions probably also apply to other developed countries, although not necessarily to the same extent. However, it is difficult to say whether this is also applicable to emerging markets.

Only the most important investment parameters taken into account in the ETF analysis, also used for other (equity) financial instruments, are indicated. Description of other features, also very important, that are specific to ETF and taken into account with due diligence, will be omitted here—both quantitative (such as index-tracking quality [including tracking difference and tracking error], total cost of ownership [including total expense ratio, bid-ask spread, premium and discount], secondary liquidity [including average daily turnover value], portfolio turnover [including turnover ratio], etc.), and qualitative (method index replication, legal and tax aspects, place of listing, credibility of fund provider, etc.). Most of them were discussed in the second part of the book.

A similar pitfall occurs when investing in various (regarding geographical exposure) international ETFs, while their economic exposure overlaps significantly.

This mainly applies to capitalization-weighted indexes or indexes based on market factors, while it does not refer to equal-weighted indexes.

It is worth noting that although the concentration of the investment portfolio is generally unfavorable from the point of view of mitigating its risk, this approach also has its advantages. A review of various empirical studies on this topic (in terms of research periods, definitions of concentration, and applied methodologies) from academics, asset managers, and other industry practitioners is presented by Mier (2017). Among recent research regarding portfolio concentration, one of the most comprehensive was carried out by Choi et al. (2017). They found, using data containing security holdings of 10,771 institutional investors’ portfolios of various types (e.g., mutual funds, hedge funds, insurance companies) domiciled in 72 countries, that in contrast to traditional asset pricing theory and in support of information advantage theory, concentrated investment strategies in international markets can be optimal. Their results showed that home country, foreign country, and industry concentration are all associated with higher risk-adjusted returns of institutional investors’ portfolios. Additionally, higher concentration in a given country (either home or foreign) and in the industries of that country is associated with better performance in the part of the portfolio allocated to that country. This evidence suggests that institutional investors concentrate their holdings in home markets as well as selected foreign markets and industries, as if they possessed an information advantage in these assets.

For some single-country indexes, only largest sector alone accounts for over 40% of total market capitalization. This applies to RTS Index (Russia)—45.0% (energy [oil & gas]); Nikkei 225 Index (Japan)—45.7% (technology); FTSE TWSE Taiwan 50 Index (Taiwan)—49.9% (technology); MSCI Tadawul 30 Index (Saudi Arabia)—50.2% (financials); and FTSE Kuwait All Cap 15% Capped Index (Kuwait)—61.0% (banks) (all data as of March 2020).

The sector composition of an equity index may be of primary significance also in terms of performance. For example, S&P Dow Jones Indices research assessed the relative importance of sectors in determining the performance of the S&P 500 Index. As it turned out, in most sectors, around half of daily variation in stock prices could be attributed to changes in sector prices (Edwards and Lazzara 2019).

It is recognized that equity indexes, including country-specific ones, should adequately reflect the structure of the economy, basically the market of public equities. Additionally, such solution is against the grain of free market principles and it may cause that local funds will not be able to attract foreign institutional investors since they typically prefer non-capped indexes. Thus, the vast majority of single-country indexes do not apply sectoral cap.

Sector restrictions are used, for example, in the following equity indexes mirrored by single-country ETFs: SOFIX Index (Bulgaria) (maximum weight of sector—20%) and WIG20 Index (Poland) (may not include more than 5 companies from a single exchange sector).

Unlike global and regional indexes, majority of single-country equity indexes usually encompass a fixed number of stocks, usually not more than 30.

For instance, the weight of the largest constituent in the ISEQ 20 Index (Ireland) is 23.8%, and total weight of three largest stocks is 56.8%; in the case of PX Index (Czech Republic), it is 24.0 and 58.1%, respectively; and in the case of BUX Index (Hungary), it is 30.8 and 87.3%, respectively. In some indexes, the largest stock accounts for over 30% (e.g., BUX Index [Hungary], KOSPI 200 [South Korea]) or even for over 40% (e.g., EGX 30 Index [Egypt], FTSE TWSE Taiwan 50 Index [Taiwan]) of its total capitalization (all data as of March 2020).

These requirements derive usually from legislation referring to diversification requirements for registered investment funds, e.g., regarding Regulated Investment Company (RIC) in the USA or Undertakings for Collective Investments in Transferable Securities (UCITS) in the European Union. Sometimes these limitations are an initiative of the index providers themselves (e.g., stock exchanges).

The capping practices are also applied, for the same reasons, in traditional, non-capped equity indexes replicated by ETFs.

In the case of other index providers, the methodology of creating capped indexes may differ from the one presented hereby.

The GICS methodology will be presented in Chapter 8.

According to OECD (2016), equity market trading concentration applies to countries with varying levels of development. For seven studied countries—five developed (USA, UK, Japan, Germany, and France) and two emerging (Turkey and Indonesia)—the share of total trading volume attributed to the 10% of largest companies in terms of market capitalization was over 70%, with the exception of Indonesia (68%). Moreover, in most of these markets, 20% of all trading was attributed to the largest 1% of companies.

Sub-regions according to the United Nations Statistics Division geoscheme for Americas.

According to country classification of MSCI as of mid-2019.

Assets of equity exchange-traded products with exposure to USA and Canada amounted to USD 2837 bn and USD 53 bn at the end of 2019, respectively, which accounted for 58.2 and 1.1% of total assets invested globally in equity ETPs (BlackRock 2020).

The majority of ETFs listed in Chile, Colombia, and Mexico are cross-listings of funds having their primary listings in the USA or elsewhere. This is due to the fact, among others, that pension funds in many Latam countries have been allowed and encouraged to use foreign-domiciled ETFs to gain exposure to other markets (Fuhr 2015).

Many American asset managers register their ETFs in these regions of the world in accordance with the applicable law (e.g., in the EU mainly in Ireland), which facilitates their distribution on those markets and enables to profile their offer for local investors.

S&P 500 Index is also by far the most used benchmark by European-listed ETFs (122 ETFs with EUR 135.9 bn AUM at the end of June 2019) (PwC 2019).

The current full list of ETFs replicating the results of this index is available in S&P Dow Jones Indices (2020).

For instance, according to the data from Crestmont Research, rolling 20-year returns of the S&P 500 Index inclusive of dividends over the past century (1919–2019) were positive, with only two exceptions (1948 and 1949) when they were less than 5% per annum. Meanwhile, it gained at least 10% per year over the trailing 20-year period in more than 40 years, and at least 13% per annum in 20 years (Williams 2020).

Due to the limited scope of the book, this list does not include many other indexes, focused on a particular segment of the US stock market considering capitalization, investment style, etc. It also does not include numerous indexes that use alternative (other than capitalization) weighting methods, smart beta indexes, and strategy (i.e., short and leveraged) indexes. A similar approach will be used to characterize the country-specific ETFs in other regions. A broad overview of the funds linked to the US indexes can be found, e.g., in Balchunas (2016). A comprehensive list of US-specific ETFs is available on professional websites, e.g., etf.​com, etfdb.​com (US-listed), justetf.​com (European-listed).

All data concerning assets of ETFs tracking Dow Jones Industrial Average Index, S&P MidCap 400 Index, and S&P SmallCap 600 Index as of end 2018 (S&P Global 2019).

The first three companies are the three largest ETF sponsors in the world. The following three are in the top 10 ETF providers globally.

Many American asset managers—for example, BlackRock, Vanguard, State Street, Invesco—offer US ETFs also in other regions of the world.

Toronto 35 Index Participation Fund was launched in Canada in March 1990. In 2000, it was merged with the Hundred Index Participation Fund to create iUnits S&P/TSE Index Participation Fund, which has been renamed the iShares CDN S&P/TSX 60 Index Fund (Fuhr 2015).

NAFTRAC was the first ETF in Latin America, launched on April 16, 2002, on Bolsa Mexicana De Valores. It was designed to track the Mexican IPC Index (currently S&P/BMV IPC Index). BlackRock acquired the fund from Nacional Financiera on May 14, 2009, and it has since been renamed iShares NAFTRAC (BlackRock 2011).

Some European asset managers register UCITS ETFs in these regions and distribute them on local markets. According to PwC research (2019), the highest number of registrations of cross-border UCITS ETFs outside Europe was in Singapore (291), Chile (103), Japan (37), Mexico (33), and South Africa (21) as of end June 2019. These ETFs are managed mostly by BlackRock (iShares), UBS, Deutsche Bank (Xtrackers), Invesco, Lyxor, Amundi, and BNP Paribas.

iShares FTSE 100 Index Fund was listed on the London Stock Exchange on April 27, 2000, as third ETF in Europe, after LDRS DJ STOXX 50 and LDRS DJ EUROSTOXX 50.

According to PwC (2019), 22 funds with EUR 16.5 bn were listed on the European platforms as of end June 2019. First ETF on DAX—DAX EX—was launched on Deutsche Boerse on January 3, 2001, by Indexchange. Today, as iShares Core DAX UCITS ETF (DE), it is part of the product family of BlackRock (Deutsche Boerse 2020).

More on the European ETF market in Marszk and Lechman (2019).

Many providers of European ETFs, in contrast to the USA, adopted “coffee shop” approach to their offerings; that is, they offer similar products based on the same benchmarks (Fuhr 2015).

According to Morningstar data, cited by Irish Funds (2018), over 70% of the total ETF assets in Europe are domiciled in Ireland and Luxembourg (54 and 17%, respectively). They are followed by France (12%), Germany (9%), and Switzerland (3%). Ireland’s leadership position results from the fact that the vast majority of US managers prefer this country as a domicile of choice due to a similar legal system, cultural similarities, and the fact that English is the primary working language in both countries.

There were 70 ETF providers in the European ETF market at the end of 2019 (ETFGI 2020).

For instance, HuaAn AM (Hong Kong) and Tachlit (Israel) offer ETFs that mirror DAX Index, and Tachlit offers ETF tracking CAC 40 Index.

More detailed information on ETF market in Asia-Pacific region can be found in Marszk et al. (2019).

Currently, it operates as Nomura Nikkei 300 Stock Index Listed Fund and is managed by Nomura AM.

Tracker Fund of Hong Kong (TraKH) was launched on November 11, 1999.

Untypical ETFs investing in China and India are WisdomTree China ex-State-Owned Enterprises Fund and WisdomTree India ex-State-Owned Enterprises Fund. They seek to track the investment results of Chinese and Indian companies, respectively, that are not state-owned enterprises, which is defined as government ownership of greater than 20%.