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ETF Specialist

Look to Africa for Faster Growth

For emerging-markets investors, Africa is high-risk but has good growth potential.

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The top holdings of  iShares MSCI South Africa Index (EZA) are primarily well-run financial services, telecom, and consumer firms, many of which have operations across different African markets. As such, this exchange-traded fund can be used to gain exposure to healthy growth trends on the African continent. It is one of only a few funds to focus on this region. This ETF can also be used tactically to add South African exposure to a diversified portfolio--South African stocks account for about 7% of the value of the MSCI Emerging Markets Index. However, investors should note that this fund does not hedge its exposure to the volatile South African rand. Consequently, depreciation in the value of the rand relative to the U.S. dollar can hurt the fund's returns.

The quality of this fund's holdings is above average, relative to its emerging-markets peers. First, earnings of the MSCI South Africa Index (in local currency) have steadily risen over the past decade, with the exception of 2009. Secondly, the volatility of returns of the MSCI South Africa Index is in line with that of the S&P 500 (usually, the volatility of a single-country emerging-markets index is much higher than that of the S&P 500). Finally, over the past five years, many of this fund's top holdings have steadily increased their dividends.

Over the past five years, the average standard deviation of returns for this fund was 25.0%, significantly higher than the comparable figure for the MSCI South Africa Index (in local currency), which was 13.5%. Most of this difference can be attributed to the volatility of the rand over this span.

Fundamental View
South Africa is currently the only African country to be included in the MSCI Emerging Markets Index at a sizable weight. Morocco and Egypt are also members of the index, but each represent less than 1% of the index's value. The remaining African countries are significantly less developed. MSCI classifies countries like Nigeria and Kenya as frontier markets, but most of the remaining countries do not qualify for inclusion in the MSCI Frontier Markets Index.

South Africa is facing a period of slower growth after a decade of strong gross domestic product growth owing to a commodity boom and significant expansion of consumer credit. Consumer confidence in South Africa is currently weak because of ongoing strikes in the mining industry. These strikes have also contributed to declining exports, resulting in a widening current accounts deficit. Other long-term issues that continue to affect the growth trajectory of South Africa's economy include a dysfunctional labor market (high unemployment and a skills shortage), high crime, and a regulatory environment that stymies competition in many industries. Some of these risks are mitigated by the fact that many South African companies have operations in markets with stronger growth. While South Africa's GDP is forecast to grow close to 3% in 2014, the east and west African regions are expected to enjoy higher growth rates of 6% to 7%.

Turning to EZA's holdings--the financials sector is one of the fund's largest sector allocations (25% of assets). South Africa has a well-regulated banking system, with a significant number of foreign players competing head-to-head with local banks. As a result, local banks are generally well-capitalized, have resilient core earnings-generating capacity, and have been successful in expanding into other African countries to boost growth. As for EZA's largest holding, Naspers (17%)--the fate of this media firm is linked more closely to Internet usage trends in China than anything transpiring in its home country. This is because the firm has a 34% stake in the Chinese Internet company Tencent Holdings. At the time of writing, this stake represented about 90% of Naspers' market value. In addition to the appreciation in the value of its Tencent stake, Naspers has also benefited from a falling rand, as the value of its Tencent investment is denominated in Chinese renminbi. This tailwind for Naspers will moderate when the rand stabilizes.

The South African rand is considered a commodity currency, as its prospects are in part linked to resource demand. (South Africa is an exporter of precious metals, minerals, and agriculture products.) Over the past decade, rising commodity prices resulted in a strong appreciation of the South African rand against the U.S. dollar, and this trend had been a significant source of returns for this fund. More recently, South Africa's rising current account deficit has been driving the rand lower. This deficit is a result of tepid demand for exports, weaker commodity prices, and growing imports. South Africa is somewhat dependent on foreign capital inflows to offset this imbalance. Any volatility in foreign fund flows, due to rising interest rates or a sudden spike in global market volatility, could hurt the value of the rand.

Portfolio Construction
This fund employs full replication to track the market-cap-weighted MSCI South Africa Index. The index is designed to measure the performance of the large- and mid-cap segments of the South African market. With 50 constituents, the index covers approximately 85% of the free-float-adjusted market capitalization in South Africa. The fund pays dividends semiannually. Over the past two years, about 90% of the dividends were deemed qualified by the U.S. Internal Revenue Service.

This ETF carries an annual expense ratio of 0.62%. The goal of an index fund is to provide the returns of the index, less fees. Consistent with this expectation, the fund has trailed its index by about the amount of its expense ratio over the trailing three years through February 2014. This indicates that the fund has done a reasonable job tracking its index.

Market Vectors Africa (AFK) invests in the largest and most liquid companies in Africa and non-African companies that generate the majority of their revenues in Africa. This fund charges an annual fee of 0.80%. There is also SPDR S&P Emerging Middle East & Africa (GAF), which is a cap-weighted fund that has more than 90% of its assets invested in South African stocks. The fund charges an annual fee of 0.59% and is small and very illiquid.

On the actively managed side, there is T. Rowe Price Africa & Middle East (TRAMX). This fund charges a fee of 1.52%. Other options include frontier-markets funds, which tend to have a significant exposure to African companies. These funds and ETFs include Wasatch Frontier Emerging Small Countries (WAFMX), Harding Loevner Frontier Emerging Markets (HLMOX), and EGShares Beyond BRICs (BBRC), which charge 2.25%, 2.21%, and 0.58%, respectively.

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Patricia Oey does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.