Turkey ETF: Excellent Run, But Risks Ahead

Turkey ETF is up more than 19% year-to-date- a sharp reversal from its disastrous performance (negative 36.3% return) in 2011, thanks to solid investor interest, as the economy showed remarkable resilience to the events in the euro-zone. (Read: Can the Vietnam ETF Continue Its Run?)

With its GDP exceeding $1 trillion in 2011 (PPP terms), Turkey is now the 17^th largest economy in the world. Services account for 64% of the economy, while industry and agriculture account for 27% and 9% each.

Turkey introduced market reforms as per IMF bailout conditions, after suffering a financial crisis in 2001. As a result of the reforms, the country has witnessed excellent growth in the last decade. (Read: Why Russia ETFs Are Not A Debt Crisis Safe Haven)

The economy grew at an impressive 8.5% in 2011 but is expected to slow down to 2.3% in 2012 and then rise slightly to 3.2% in 2013, per IMF.

Despite solid growth potential, the economy faces some serious challenges from its growing current account deficit (~10% of GDP), rising inflation and low savings rate. (Read: Spanish Bailout: Did It Help European ETFs?)

The deficit is mainly being financed by short-term capital flows (hot money- which can change direction quickly). Further, energy imports account for about half of its current account deficit, leaving the country vulnerable to increase in oil prices.

According to the central bank, $10/barrel increase in crude price adds 0.4% to inflation, 0.7% of GDP to current account deficit and reduces GDP growth by 0.5%, over one-year period. (Read: PUW: Crushing The Clean Energy ETF Competition)

Though inflation touched 11.1% in April, the central bank has maintained its target of bringing it down to 6.5% by the end of the year. However per IMF, inflation is expected remain high at 10.6% in 2012.

In order to control inflation the central bank has been tightening monetary policy by varying the overnight rates for banks while it has left the key rate unchanged. The central bank began to tighten in the second half of 2011, which did result in controlling the domestic demand to a certain extent.

Last month S&P revised the outlook on the country to stable from positive due to concern that “less buoyant external demand and worsening terms of trade could inhibit Turkey’s economic rebalancing”. The agency maintained its sovereign rating at BB, which is two notches below investment grade.

Fitch had lowered its outlook on Turkey in November last year.

In fact, Turkey’s dependence on volatile foreign capital flows is a matter of great concern for the economy, going forward. On the other hand, Turkey does not attract much foreign direct investment due to its rigid labor laws and regulations.

As pointed out in a recent World Bank report, growing imbalances (high inflation, large and growing current account deficit), make the country vulnerable to adverse developments in the investor sentiment.

iShares MSCI Turkey Investable Market Index ( TUR - ETF report )

TUR tracks the MSCI Turkey Market Index, which is a capitalization weighted index that aims to capture 99% of the Turkey equity market. The fund was launched in March 2008 and has attracted $367 million in AUM so far.

The fund charges 0.59% annually for expenses. In terms of sector exposure, financials constitute almost half (47%) of the assets, followed by consumer staples (14%) and industrials (11%). Though the ETF currently has 99 holdings, it is top-heavy, with the top 10 holdings accounting for almost 61% of the assets.

Turkey’s banks are adequately capitalized and the regulatory norms are in compliance with the International norms.

With its focus on financials and heavy concentration is a top few companies, the fund has actually managed to outperform the Istanbul National 100 Index, which hasreturned 13.6% year-to-date. The outperformance is also supported by thecurrency’s more than 3% appreciation against the US dollar this year.

However we may like to add that the Turkish Lira has been very volatile and was down 17.5% (one of the worst performance among the emerging market currencies) last year. The investors should thus also keep currency volatility in mind while investing in this fund.