Market Overview

The South Korea ETF Myth

The South Korea ETF Myth

Shares of the iShares MSCI South Korea ETF (NYSE: EWY) are down 19.2 percent year-to-date and with what likes a small loss for the $3.08 billion fund today, EWY is inching closer to a 20 percent loss, or official membership in bear market territory.

That alone should be enough to keep investors away South Korean stocks. So should the roster of single-country emerging markets ETFs that have outpaced EWY this year. If the acronym were BRICS instead of BRIC, EWY would be the second-worst performing major ETF of that quintet trailing only the iShares MSCI Brazil ETF (NYSE: EWZ).

Said another way, ETFs tracking China, India, Malaysia, the Philippines and Russia have all been better than EWY this year. So perhaps it is not surprising that in the past week a cacophony of positive valuations calls has emerged on South Korean stocks. Goldman Sachs got the ball rolling at the start of this month. Citigroup followed. On Tuesday, Bloomberg reported JPMorgan Asset Management and Charlemagne Capital are bullish on South Korea. Guess why. Valuations.

Beleaguered investors that hold scores of diversified emerging markets ETFs where South Korea is a significant country weight would love to see stocks there as rise. Undoubtedly, declining equities in the Asia's fourth-largest economy have played a part in the allegedly alluring valuations now found among various emerging markets ETFs.

However, EWY and its constituents are cheap for good reason. Actually, two good reasons and both seemed to be ignored in startling fashion by South Korea bulls. Those being the weak yen and the end of U.S. quantitative easing. To be fair, South Korea recently boosted its 2013 GDP growth forecast to 2.7 percent from 2.3 percent. And to continue being fair, it must be acknowledged that bankers and policymakers there have overtly said the two biggest risks facing the economy are the weak yen and the end of U.S. easing.

It is not a coincidence that South Korea has been one of the most vocal critics of Japan's efforts to weaken the yen. Nor is it a coincidence that in a year when the yen is worst-performing developed market currency in the world that EWY is down over 19 percent.

Bulls might say the weak yen is "priced in" with regards to South Korean stocks. Perhaps USD/JPY at 100 or even 105 is. USD/JPY at 110 or higher, a possibility that could be seen later this year, is not priced in.

There is another issue to consider regarding EWY and South Korean equities. To be clear, we are not picking on anyone, but the point about Vanguard selling South Korean stocks as a possible downside catalyst has again been raised.

Vanguard, the third-largest U.S. ETF issuer, until late June had gradually been reducing the Vanguard FTSE Emerging Markets ETF's (NYSE: VWO) weight to South Korea because that ETF was making an index change.

As was announced last October, Vanguard switched VWO to the FTSE Emerging Markets Index from the MSCI Emerging Markets Index. FTSE does not classify South Korea as an emerging market. Blaming Vanguard, even partially, for the decline in South Korean stocks is an argument that does not hold merit. Until the end of June, VWO was benchmarked to a transition index that ensured the gradual and orderly sale of the ETF's South Korean exposure. Basically, the transition index was an avenue for Vanguard to NOT upset the market.

Investors knew this was coming in October 2012, giving the market ample time in which to adjust to the fact that one day, VWO would no longer hold Samsung, Kia and other South Korean stocks.

South Korea is cheap not because of Vanguard, but because of the weak yen and the looming end of QE. Since neither of those scenarios are going away anytime soon, EWY and South Korea will remain inexpensive and endorsers of that bullish thesis, yes this includes Goldman, will be proven wrong.

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