Tapping Into Israel: Two Vastly Different Choices

September 22, 2009

Israel is moving up, at least in some indexes. But the options for fund investors are limited. Here are the two most readily available options.

With so many foreign markets overcrowded after this year’s BRIC-led equity comeback, it can be hard these days to find somewhere to put your money that presents an attractive risk/reward equation.

Since being upgraded to developed-market status last year by index provider FTSE Group, Israel has become, to some investors, the ideal overlooked destination. In 2008, foreign direct investment (FDI) rose to nearly $10 billion, just shy of the country’s record $14 billion reached in 2006 when Berkshire Hathaway made a $4 billion acquisition there.

Those flows have helped to push the Tel Aviv 100 Index (TA100) into positive territory in the past 12-month period; with gains of around 12.5 percent, Israel’s largest index is outperforming the S&P 500 by more than 20 percentage points.

And those returns have been even stronger recently. In the May-to-July period this year, foreign direct investment accounted for $1.02 billion of share purchases, with around 10 buyers for every seller in July, according to the latest data from the Bank of Israel.

As a result, the TA100 surged over 60 percent in value year-to-date, far beyond other developed-country indexes, and almost the same amount as China’s Shanghai Composite Index (63 percent).

Part of the attraction for many investors may be in the relatively diversified range of growth sectors: Israel’s economy is fueled by a mix of high-tech, chemical and metal, and service industries.

For index investors, accessing Israel’s growth has so far proved frustrating. For one, index providers (and therefore, ETFs by proxy) seem uncertain whether the country should come as a part of an emerging markets or a developed country package. In the popular MSCI benchmarks, for instance, Israel is currently transitioning from emerging to developed markets status, and to developed markets in the FTSE indexes, a process that will take nearly a year to complete.

There are passive, more broadly based ETFs with a bit of Israel in their portfolios. But they tend to deal with massively volatile, mostly high-growth countries that obscure the numbers so much as to render any exposure to Israel’s growth meaningless.

Two Israeli Funds: Pros & Cons

There are two options for investors looking to take specific advantage of the growth in Israeli securities: iShares MSCI Israel Capped Investable Market ETF (NYSEArca: EIS) and The First Israel Fund (AMEX: ISL), a closed-end fund that trades as an American depositary receipt. Both funds invest in Israeli-listed securities, and not in ADRs.

ISL is much more expensive than its ETF rival. While EIS is a passive tracking fund with a 0.63 percent fee, ISL is a closed-end fund actively managed by Credit Suisse, which commands a 1.7 percent fee.

Analyzing the performances of the funds over a 12-month and year-to-date timelines reveal how vastly different both funds are, and not in the way most closed-end funds would expect. On a 12-month basis, ISL is a significant market underperformer, with losses of 2.8 percent, whereas EIS is in the green by 9.8 percent.

Scale the timeline back to Jan. 1, however, and ISL looks significantly better: It has posted a 66.4 percent gain year-to-date versus 58.6 percent for EIS. ISL also trades at a discount to its net asset value of nearly 10 percent, which may make it attractive to investors searching for bargains in a market that is rapidly heating up.

On a constituent basis, ISL is well diversified, with 49 percent of its capital invested among the fund’s top ten holdings. Its largest holding, Teva Pharmaceutical Industries, comprises 9.3 percent of the fund, and has risen 12.6 percent in the last year.

EIS' modified market-cap weighting approach puts the fund more heavily into Teva, with a 23 percent stake in the $46 billion multi-national pharmaceutical giant. That focus has constrained the ETF’s growth relative to its closed-end rival in the year-to-date period, since pharmaceutical companies tend to be more defensive investments than higher-growth sectors, such as high-tech or telecoms.

Among ISL’s top ten investments, large-cap growth companies such as Bezeq Israeli Telecommunication, Housing & Construction Holdings and Star Ventures Enterprises form 12.1 percent of the fund.

Bezeq Telecom constitutes a much smaller part of EIS’s portfolio (4.61 percent), although the firm does have a significant weight in technology firms (15 percent of the portfolio). That includes large positions in fast-growing firms like Check Point Software Solutions and Nice Systems, which zoomed up 70 percent and 40 percent, respectively, year-to-date.

Despite its more diversified investment approach, ISL is more heavily weighted in the financials sector. ISL has a 31.9 percent focus among commercial banks, venture capital investment funds and insurance. By comparison, financials-related companies comprise just one-fifth of EIS’s weightings.

In large part, that helps to explain ISL’s higher volatility and outsize gains this year, as the fund’s Beta has zoomed up to 1.2 from 0.8 previously, meaning its daily price swings now outperform those of the S&P’s.

Going Forward, What’s The Best Bet?

For many investors, ISL’s closed-end status is a big turn-off versus EIS’s ETF structure. And, curiously, for an index fund, EIS seems to be less vulnerable to the undulations of the global economy.

Much of that may be due to the fact that ISL has a significant exposure to venture capital projects, many of which are technology-related. By comparison, the seeming over-weight in the play-it-safe Teva (it comprises just 9 percent of the TA 100) and a lack of exposure to next-generation small-cap technology names makes EIS unattractive to some buyers.

“[It’s] interesting, but as a technology investor with exposure to Israel, I’m looking to invest in the sexier, high-tech firms that capitalize on Israeli ingenuity, not local cellular operators facing 120 percent subscriber penetration,” wrote Zack Miller, a U.S.-based asset manager and equity commentator, in a note when the fund was born.

Technology is a key aspect to Israel’s economic growth: in 2008, 50 percent of FDI was in technology-related ventures. By that measure, ISL’s 10.4 percent focus in the venture capital sector may ultimately yield outsize gains. Still, for more skittish investors who just want a bit of low-U.S.-correlated exposure, EIS trumps the two.

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