Choosing The Best South Korean ETF

As the number of ETFs focused on South Korea increase, investors have some decisions to make.

Last week’s launch of Horizons’ new ETF tracking Korea’s KOSPI 200 Index is the latest in a recent surge in Korea-focused ETF launches.

For years, investors looking for broad, cap-weighted exposure to South Korean equities had all but one choice: the iShares MSCI Korea Capped ETF (EWY | B-95), the bellwether in the space that now has more than $4 billion in assets.

But over the past six months, we’ve had three new launches, including two currency-hedged ETFs and the Horizons Korea KOSPI 200 ETF (HKOR), bringing the total number of Korea ETFs to five. The fifth in my tally is the $5.2 million First Trust South Korea AlphaDex ETF (FKO | F-36), which launched in April 2011.

With Korea clearly now in play, it’s time to dissect the various strategies.

Hedged Vs. Unhedged

A good place to start is determining whether you want to hedge your exposure to the Korean won. Knowing whether you want currency-hedged exposure would immediately eliminate two or three funds from your pool of choices.

For traditional broad, unhedged exposure, EWY has been the de facto play for more than a decade. EWY trades more than $3 million a day at penny-wide spreads and tracks the MSCI Korea 25/50 Index.

Still, I think Horizons’ new HKOR has the potential to significantly challenge the goliath in the space.

HKOR holds 200 Korean blue chips selected by market capitalization, liquidity and sector representation, making it the most comprehensive Korea ETF to date. In comparison, EWY holds 100 companies, capturing 85 percent of Korea’s market cap.

HKOR also has the benefits of a highly liquid index that’s tied to a massive derivatives market—the KOSPI 200 is Korea’s equivalent of our S&P 500.

The index’s options and futures markets should help market makers lower their hedging risks and costs, tightening spreads and appealing to institutions. HKOR’s first week of trading reflects that interest, with volumes averaging more than $240,000 a day.

But besides the fund’s depth in underlying liquidity, the first thing that jumped out at me is HKOR’s 38-basis-point expense ratio, or $38 for each $10,000 invested. To put things into context, that’s 23 basis points less than EWY—not to mention that EWY also has issues with tracking its index, with a median 12-month tracking difference of -1.17 percent over the past two years (see below).

EWY Portfolio Management

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What about sector representation?

Since EWY and HKOR are cap-weighted, the top 10 holdings are closely aligned with each other. Being representative of the broad Korean market, that also means both funds are heavily concentrated in Samsung Electronics.

Source: Issuer Websites
As of 3/10/2014

Therefore, their returns are likely to be highly correlated.

To me, it really boils down to their expenses and liquidity. While the liquidity aspect should appeal to institutions, HKOR’s lower costs appeals to all investors.

The Case For Won-Hedged

The Japanese yen’s 2013 plunge due to Abenomics—Japan’s economic revitalization program spearheaded by Prime Minister Shinzo Abe—really brought to light the significance of currency exposure in ETFs for U.S.-based investors.

South Korea has been affected by the plunging yen perhaps more than any other nation, which is why I think Korea looks especially interesting from a currency-hedging perspective.

Korea’s export-led economy draws many comparisons to Japan. Many South Korean multinationals in the auto and electronics sectors—like Samsung, LG, Kia Motors and Hyundai—directly compete with Japan’s mega-caps in the same sectors, like Toyota, Honda, Panasonic and Sony.

Since the beginning of 2013, the Korean won has surged more than 18 percent against the yen, eating into profits of Korea’s exporting mega-caps, and increasing speculation of intervention from the Bank of Korea to ease any further surge in the Korean currency to restore competitiveness of Korean exporters.

If you’re looking to neutralize your exposure to the won, the WisdomTree Korea Hedged Equity ETF (DXKW) and the db X-trackers MSCI South Korea Hedged Equity ETF (DBKO) are worth a look.

While the two funds both hedge their won exposure, they are vastly different in their index methodologies, so it’s important to know what you’re getting.

DBKO tracks the same cap-weighted and cap-selected index as EWY, simply with a currency forward contract overlay, so you get purer equity exposure that’s fairly marketlike.

Meanwhile, DXKW holds only 50 stocks and weights them by earnings, while tilting its exposure toward exporters. It also caps any one holding at 10 percent, significantly reducing exposure to Samsung. This all leads to sizable differences in sector exposure.

As shown above, technology takes a huge haircut in DXKW, while consumer cyclicals, industrials and basic materials get a bump up in weighting. Notice also that DXKW has zero financials exposure, since the fund strips out companies that get more than 80 percent of revenues domestically.

That means financial mega-caps like Shinhan Financial and KB Financial—both in EWY’s top 10 holdings—are missing entirely.

Korea Rising

Despite the sell-off in emerging markets and a plunging yen in 2013, South Korea held up extremely well compared with most other markets that dominate the MSCI Emerging Markets Index.

Charts courtesy of StockCharts.com

I think investors have taken notice of South Korea’s resilience in the face of these two major obstacles. For example, billions of dollars were pulled from emerging market ETFs in 2013, but EWY actually had net inflows of $950 million last year.

In some ways, South Korea can be seen as a barometer of the health of global consumers. South Korea gets more than half its economic output from exports. It’s also in the unique position of being the only “emerging market” with major global brands.

With regard to the current ETF offerings, I’m a fan of the currency-hedged products at the moment. The Bank of Japan looks determined to do what it takes to beat deflation in Japan and keep the rally moving, which means further stimulus is very possible.

If the yen continues its slide, pressure will likely build for the Bank of Korea to intervene into the currency markets.

On the flip side, if Abenomics falters—another real possibility—a rising yen would also be a boon for Korean exporters.

Of the two currency-hedged products, strictly from an exposure perspective, I like DBKO for its marketlike exposure. Even though Korea gets most of its growth from overseas, in a maturing economy like Korea, I’d still prefer to have exposure to its financial system (which is missing in DXKW).

That said, DBKO just hasn’t caught on with investors yet.

Volume is still razor-thin, and the fund can go for days without any trade executions. In comparison, DXKW, which launched about two months before DBKO, trades more than $72,000 on most days.

Over the long run, I wouldn’t rule out HKOR either. The fund looks to have institutional backing and looks ripe for inflows if Korea’s market rallies.

Whatever your views on the Korean won, I think one thing is certain: EWY looks to have some serious competition in the coming years, and its sole dominance will likely be challenged.

At the time this article was written, the author held no positions in the securities mentioned. Contact Dennis Hudachek at [email protected], or follow him on Twitter @Dennis_Hudachek.