Surf's Up Down Under

Lucky? This lucky country’s economy is on a record-breaking 14-year roll. The big question: Will it continue? Just imagine: From a few convicts dropped ashore in 1788, Australia has developed into a first-class global economy. The reforms enacted by former Prime Minister Bob Hawke and Treasurer Paul Keating during the 1980s set the stage for a remarkable run of prosperity. Specifically, they slashed import tariffs, floated the currency and reduced the power of big labor. The current prime minister, John Howard, who has been elected four times, has continued and expanded these reforms riding a wave of economic growth – 14 years of uninterrupted 4% to 5% growth. The national debt has been virtually eliminated, the currency is strong, the government has recently signed a free-trade pact with America, and it is starting to negotiate a pact with China. Australia received $42 billion in foreign direct investment in 2004. This is all great news, and our portfolio allocation in the Australia iShare (AMEX: EWA) has done very well, with a 105% gain over the past two years. The Australian iShare is up 15% so far this year and provides investors with exposure to about 60% of the total stock market. Some Warning Signs The question is of course, what should we do now. When things are going this well for so long, investors need to be skeptical and weigh the potential upside with the downside risk. - A shortage of skilled and semi-skilled workers and relatively high labor costs (minimum $400 a week). - Complicated and rigid labor rules continue to hamper productivity growth, which seems to be slowing. - The total tax take by the Australian federal government is 22%, which is higher than the rest of Asian competitors and the U.S. (average of 16%). - From 2000-2004 housing prices were up 100%, and household debt is now 160% of disposable income. Australia is taking some measures to address these matters. It recently enacted a $17 billion cut in personal income taxes over three years, and the independent central bank is raising rates. The leadership has also introduced a package of “radical” labor reforms, which if enacted would also be a big plus. The aim is to give employers more flexibility and to bring labor negotiations down to the local level. The measures would increase probationary period for new employees from three to six months, exempt businesses with less than 100 employees from unfair dismissal laws, and favor individual contracts over collective bargaining. All of these measures will be fought by the Labor Party and trade unions. While much is made of Australia’s dependence on China and commodity exports, the Australian economy is well diversified, with 5% of gross domestic product attributed to mining, 5% to tourism and 80% to services. It also has the third-largest stock market in the region and a leading regional financial center. Taking Profits After looking closely at the situation, I have decided to keep Australia in our portfolio, but will take some profits by halving our position. Here is my reasoning: - The decline in housing prices has been incremental and has therefore not affected banking, consumer and construction stocks as expected. - International fund managers are underweight on Australia. - The market is not especially expensive. The 12-month forward price-to earnings ratio is about 15, in line with the average over the past three years and below a high of 18. But keep in mind that this low multiple is based on forward and aggressive forecasts of corporate profits. - Average dividend yield for Australian stocks is around 5%. One company to keep an eye on is BHP Billiton (NYSE: BBL), the world's biggest mining group, which reported an 85% rise in net profit, compared with a year ago, to $6.5 billion for the year ended June 30, 2005. The Anglo-Australian firm set a new Australian corporate profit record, and after being up sharply in 2003 and 2004, it has confounded skeptics by going up 26% so far this year. The company's good fortune, like that of other mining concerns, comes from rising demand in China. Another great Australian mining company is Rio Tinto (NYSE: RTP), which has a lower valuation because it doesn’t have oil and gas operations, which contribute about 30% of BHP’s total revenue. Last Bit of Advice The center of gravity for the world’s economy is shifting to the Asia-Pacific region, and Australia is in the sweet spot. Keep an eye on housing prices and corporate profit performance, but for now keep some exposure to Australia in your global portfolio. For more information go to www.chartwellasia.com or call 877-221-1496

Buying Into Japanese And German Exporters

With the euro down nearly 15% this year and at a two-year low against the U.S. dollar, the world’s largest exporting nation is worth a good look. So is another country that has thriving exports in spite of a stronger currency. We’re talking about Japan and Germany, respectively, the world’s second- and third-largest economies.

The top lines at leading German industrial companies are rolling in with impressive numbers for an almost zero-growth economy. Quarterly sales at Siemens rose 13%, the fastest since 2003. BMW’s sales rose by 11% in the third quarter, although high raw-material costs and pricing pressure resulted in weak net profits. A bright spot is Asia, where BMW expects to sell 150,000 cars per year by 2008.

Overall, German exports are up for the third-straight month and sales to countries outside of the European Union rose 18% annually from a year earlier. Clearly, the Germans are good at making stuff and selling it to the world, and the weaker euro is helping spur growth. Germany’s DAX stock index is taking notice and is up nearly 20% year-to-date.

Meanwhile, U.S. exports are up a paltry 2% since 2000. Although exports to China are up 35% during this same period, Americans are now buying seven times more from China than we are selling to them. A good reason why is that, according to research by Morgan Stanley's Stephen Roach, consumer spending represents 71% of America’s gross domestic product. The figure is 42% for China and 55% for Japan.

Speaking of Japan, the aftermath of the financial bubble has obscured the fact that it too, remains an exporting powerhouse, despite a currency that has risen more than 20% since 2002 and 13% this year alone. Just look at Japan’s current account surpluses over the past three years: $113 billion in 2002, $136 billion in 2003 and $172 billion in 2004. China is a major market, and despite political difficulties, bilateral trade between China and Japan now exceeds trade between Japan and America.

A majority of Japan’s exports are manufactured goods and components. Fifty percent of its exports to China in 2004 were electrical equipment and machinery, and its top exports to the world include autos, electronic components, optical instruments, imaging equipment and computer parts.

Much is made over China’s huge trade imbalance with America, which reached $126 billion in the first eight months of this year. No doubt a sizable share of Chinese exports to America are chock full of Japanese components. While some of these components were made in offshore facilities, many were made in Japan, which has been able to hold on to its industrial base better than America.

How do they do it? First, the Japanese are continually moving up the value-added curve and are careful to keep the R&D and manufacturing of sophisticated components close to home, while outsourcing the low-end to low-wage countries.

Secondly, even though China’s wages are about 5% of Japan’s, factory automation has lessened the importance of labor costs. For advanced high tech products, it accounts for only 10% to 15% of total costs. Having manufacturing closer to home also shortens new product lead times and increases cooperation between R&D and production teams leading to a crucial edge in staying ahead of its nimble competitors. Supply lines of 2,000 miles can be problematic.

Perhaps most important, there is the critical issue of protecting intellectual capital. Having research, development and production closer to headquarters better protects proprietary technologies.

Canon, Sharp, Hitachi, NEC and Toyota are all good plays on Japan’s manufacturing edge, while Sony will continue to lag until it boosts its R&D and catches up in product development.

The iShares MSCI Japan Index exchange-trade fund is an attractive option, since it has about 50% exposure to Japan’s manufacturing sector with an annual expense ratio of only 0.59%. Similarly in Germany, the iShares MSCI Germany Index is loaded with that country’s top exporters and would be an excellent proxy for overall German export growth.

ETFs Unplugged

Is your financial advisor missing a critical piece to the ETF?

Exchange-traded funds (ETFs) are great investment tools but most have a flaw that investors and advisors usually miss. Let’s take a look under the hood and introduce some new and innovative ETF products.

Essentially, ETFs are nothing more than an index fund that trades like a stock. Because of their simplicity, flexibility, low cost and tax efficiency they are growing fast. Last year the Barclays iShares family of ETFs brought in more new money than the Fidelity mutual fund machine.

Diversification

Unfortunately, many investors and advisors are building portfolios of ETFs without looking inside the box and seeing where the money is going. One of the chief goals of a portfolio is diversification and many ETFs are not very diversified. This is because the companies in the ETF are weighted by size – specifically by the market value of its outstanding stock. This can result in an unwise concentration of risk and uneven performance.

The index fund community’s preoccupation with market cap weighting may have a strong theoretical basis but to me it is contrary to common sense. To be blunt, I pay very little attention to it while building global portfolios for clients.

Most investors would agree that just because a company is bigger doesn’t mean that it is a better investment. Let’s look at the most well known index – the S&P 500 index. Many investors think that investing in the S&P 500 means that their money is being divided equally between 500 companies. This is far from the truth. Because the companies are weighted by size, 22% of your investment is going to the ten largest companies in the index and 60% of your investment is going to the largest 50 companies in the index.

Unequal Weighting, Unequal Returns

This is why I have been advising clients to invest in the Rydex S&P 500 equal-weight ETF (RSP) which weights each company in the index equally. In 2003 the equal weight S&P 500 ETF beat the S&P index by 11%, in 2004 it beat the index by 5% and year-to-date it is up slightly while the S&P index is down.

In my book, “The New Global Advisor”, I ask readers a provocative question. If you wanted exposure to the dynamic biotechnology industry, would you prefer to primarily invest in a few large well know biotech companies or would you prefer to spread your investment over thirty biotech companies? If you’re the former, you might invest in the iShares Nasdaq Biotechnology ETF (IBB) whereby 25% of your investment would go to three companies. For those that prefer broader exposure including some small cap companies, I have discovered a new family of ETFs called Powershares.

The new and innovative Powershares family of ETFs essentially creates its own indexes based on rules-based quantitative analysis that they refer to as “intelligent indexes.” This seems to me to be more useful than blindly following market cap weighted indexes. There are two Powershares that I particularly like at this point.

Two I Like

The first is the biotech Powershare (PBE) that contains 30 biotech companies. If its holdings were weighted by market cap, two companies would account for more than 60% of its holdings. Instead your exposure is spread among 30 different companies with no company accounting for more than 5% of the total. 30% of your exposure is to large cap companies, 26% is to mid-cap companies and 43% is to small cap companies.

The biotech Powershare is an aggressive position so don’t get carried away. I think it is a smart play on the tremendous opportunities for capital appreciation in the biotech industry which is showing some momentum after trading sideways since early 2004. The annual fee is only 0.60%.

The other Powershare that I like is the International Dividend Achievers Powershare (PID) that contains 42 ADRs traded on U.S. exchanges. I am usually not a big fan of ADRs since they usually trade at a premium to the underlying security but they do offer some comfort to investors since they meet U.S. reporting requirements and can be easily purchased on U.S. exchanges. The ADRs in this Powershare have to pass a stiff test: five fiscal years in a row of increased dividends. Again the top holdings are no more than 5% of the total index and so you get great diversification.

A Better Way to Get Global Diversification

One problem with the most widely used international index, the MSCI Europe, Asia & Far East Index (EAFE) is its concentration in Japan and the United Kingdom which account for almost 50% of the index’s total value. Meanwhile exposure to promising countries such as Ireland and Hong Kong are less than 2%. Last year, this Powershares index beat the MSCI EAFE index by 7% and companies in the ETF averaged a 29% return on equity. The index is re-balanced quarterly and has an annual fee of 0.50%. Right now 67% of the companies in the index are large cap, 20% are mid-cap and 13% are small cap companies.

Getting the right blend of ETFs takes some time and effort. Remember that all ETFs are not equal so choose carefully.

Eight Rules For ETF Success

Managing a global portfolio of exchange-traded funds (ETFs) is a great way to build a diversified portfolio with exposure to equities around the globe. Fortunately, you need not be a rocket scientist to do this, but many investors fail to observe some basic guidelines, and it can get them into real trouble. Follow these eight steps and sleep easier.

1. Liquidity Comes First: Before you even think of building an investment portfolio, you should set aside about six months of income in a “rainy day” account. This could be put into a money market fund or U.S. Treasury securities. Having this money set aside will ease your mind and allow you to be more open and creative with your global portfolios.

2. Separate Portfolios: You should separate your core conservative portfolio from your growth portfolios. With the core conservative portfolio, your top priority is capital preservation, and growth is a secondary consideration. Your growth portfolios are more speculative, with capital growth as the primary goal.

3. Really Diversify Your Portfolios: You need positions in your portfolios that are likely to offset each other as unexpected events and market movements become a reality. This is not accomplished with different sectors of ETFs or a mix of small-cap, mid-cap and large-cap ETFs. Rather the goal is to have some investments that are on both sides of risks.

For example, if the U.S. dollar declines, have some investments in precious metals or denominated in other currencies, such as Switzerland or Australia or Singapore ETFs. If inflation heats up, have some investments that hedge this risk such as timber, gold or Treasury inflation-protected bonds (TIPs). If political events or policies in one country take a turn for the worst, it is helpful to have investments in other well-developed countries to offset any loss of value. You get the idea, spread your risk and avoid having one ETF account for more than 5%-10% of your core portfolio.

4. Be Careful Which Countries You Pick: You need some guidelines to help keep you from getting carried away and having too concentrated a position in a particular country or region. In particular, take a good look at the following: 1) the stability and overall political and corporate governance; 2) the legal environment, respect for contracts, low levels of corruption, due process and rule of law; 3) the macroeconomic environment including fiscal discipline and currency strength; and 4) political risks that could affect financial markets.

Keep in mind that the quality of the countries you choose to invest in is the primary but not the only factor. The price or valuation of a country’s stock market is also extremely important. Oftentimes, the best time to buy into a country’s stock market is when it is beaten down, but there are signs that its economic and political problems will sharply improve. If you have a long-term perspective, you might consider annuities specially structured for ETF portfolios.

5. Minimize Company Risk by using our “buy countries, not stocks” strategy. Instead of trying to pick the best three stocks on the Tokyo Stock Exchange, why not just minimize company risk by buying the iShares MSCI Japan Index, which tracks the Nikkei 225 and spreads this risk across 225 Japanese companies.

6. Monitor ETF Country And Company Exposure: Be careful to look under the hood of ETFs to see where your money is going. For example, let’s look at the iShares MSCI Emerging Markets ETF. It invests in 26 different countries, so it is natural to think that you will get broad exposure to all 26 countries. You would be wrong: 50% of your investment in this fund is going to four countries: South Korea, South Africa, Taiwan and China. In addition, incredibly, 7.5% is going to one company, Samsung Electronics of South Korea.

The same is true for the MSCI Europe, Asia and Far East index. It contains 21 developed countries, but 48% of the money you invest would go to just two: Japan and the United Kingdom. Meanwhile, less than 1% would go to Singapore and Ireland! Country specific ETFs such as the new iShares FTSE/Xinhua China 25 Index can also have a fair amount of concentrated risk. Although the China ETF tracks a basket of 25 companies, the largest five companies account for nearly 50% of your exposure.

7. Cut Losses With A Trailing Stop-Loss Policy And ETF Put Options: We have all been there. You buy a stock or fund, and it appreciates in value rapidly. Then it stumbles and begins to decline. What do you do? Should you buy more, let it ride, or sell? Save yourself a lot of pain and agony by following a simple rule. If a position ever falls more than 20% from its high, sell it immediately and reassess the situation. If you invest in an ETF with a sizable downside risk, why not spend a few hundred dollars to purchase a put-option as an insurance policy?

8. Rebalance Your Portfolio: At least annually, you need to make some changes so that you are not overly exposed to countries that have higher risk factors and volatility. One way is by selling some shares of your winners and increasing exposure to under performers. This accomplishes another goal, locking in gains and taking some money off the table. Remember, only a fool holds out for top dollar, especially in the more volatile emerging market countries.

Building your portfolios with low-cost, tax-efficient ETFs is a smart strategy, but don’t set it on auto pilot.

For more information call 877-221-1496