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Israel ETF Investing 101

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Israel has had a tumultuous history since its inception back in 1948. Be it the age old conflict between its immediate neighbors or with much larger states like Iran, Israel has continually been in the spotlight from a geopolitical perspective.

However, amidst endless political animosity and conflict, the nation has been able to make a name for itself on the economic front. The country’s economy has proven to be quite resilient and a hotbed of technological innovation, despite constant worries from its political situation.

The country’s strong economic policies and adequate capitalization of banks have coupled with efforts to remove barriers to trade and capital flows to the rest of the world have gone a long way in facing the challenges posted by the global economic downturn (see Peru ETF Investing 101).

In fact, the International Monetary Fund (IMF) has said that “Israel economy is strong despite the global crisis”. The IMF has also praised their fiscal policies that have kept the economy relatively safe from the economic contagion affecting developed economies in the rest of the world. Also, a low rate of inflation and modest levels of unemployment are the key positives for the nation going forward according to the IMF.

However, political and social unrest have acted as a major bottleneck in the Israeli economy growth trajectory.  As Iran becomes more and more likely-- at least according to some—a nuclear power, it is widely believed that the Islamic nation will clash with the Jewish state before long.

After all, along with Israel, many of the major Western nations (including the U.S.) have also opposed the idea of Iran possessing a nuclear weapon. Given these circumstances, it is quite possible that the two nations might square off in the near future. Although this is by no means guaranteed, if it happens, it could have serious negative implications in the Israeli economy (read Is The Israel ETF Back On Track?).

Nevertheless, some maintain that a diplomatic situation will be achieved with Iran or that the issue will not boil over into a full scale conflict. As we have seen in North Korea, at least so far, a rouge state with nuclear weapons is not always the end of the world, and if anything, can allow investors to get into nearby countries at a geopolitical discount.

Given this, some investors may want to consider a closer look at the Israeli economy despite the headwinds that are currently facing the nation. For this exposure, investors should probably look to the top ETF choice in the nation for a diversified play on the still strong Israeli economy:  

The iShares MSCI Israel Capped Investable Market ETF (EIS) is pretty much the only product from the ETF space that provides an opportunity for a pure play in the Israeli equity space. It tracks the MSCI Israel Capped Investable Market Index, which in turn tracks the performance of the Israeli equity markets. Although the equity ETF was launched in March of 2008, it has managed to amass $76.50 million in its asset base.

The product charges a net expense ratio of 59 basis points per annum and pays out 2.74% as yield. The EIS portfolio is composed of 70 stocks across various sectors.

The ETF has its assets spread across the entire spectrum of market capitalization with a particular bias towards large cap stocks. However, it has a relatively lower average daily volume of around 19,000 shares which give rise to relatively high bid-ask spreads.

EIS has a large exposure in the Financial (28%) and Healthcare (22%) sector as these two sectors taken together, account for around 50% of its total assets. 

Among other segments, it also places its bets heavily in the Material (15%) as well as Information Technology (14.78%) sectors with double digit exposure. Industrials (6.17%), Consumer Staples (2.94%), Energy (2.30%) and Consumer Discretionary (1.32%) are the other sectors in which the ETF has a weighting in (read Forget the BRIC ETFs, Focus on the PICKs).

However, looking at it from an individual holdings point of view, it is revealed that EIS tends to place its bets heavily in the top five holdings which together account for almost 53% of its total assets.

Moreover, a single pharmaceutical company with the largest holdings-- Teva Pharmaceuticals Ltd (TEVA - Free Report) -- accounts more almost 21.61% of its total assets. Such disparities in the individual holdings could result in a lack of diversification (in terms of company/event specific risk) when compared to other ETFs.

It is also prudent to note that the ETF has an R-Squared value of just 64% against the S&P 500 (since inception). This implies that EIS has low levels of correlation with the broader U.S. equity market. It thus also provides an opportunity for international diversification for U.S investors seeking exposure in the Israeli economy (see Three ETFs With Incredible Diversification).

Also, EIS being a function of emerging market equities one might imagine that the ETF is relatively less volatile than its other counterparts in the region with a three year annualized standard deviation of around 24%.

Although iShares MSCI Israel Capped Investable Market ETF (EIS - Free Report) posted phenomenally high returns in 2009 (80%) and 2010 (15%) for two consecutive years post the sub-prime mortgage crisis, the ETF lost its way after the latter half of fiscal 2011 amidst the deteriorating global economic conditions and its slippery political relationship with neighbor Iran.

As political intensity heats up between Israel and Iran, investors shun away from the ETF causing massive sell offs during late 2011. This caused the ETF to lose almost 33% for the year 2011. However, it rebounded somewhat in the first quarter of fiscal 2012 returning around 8% for the quarter ending 31st March 2012.

Still, this was short lived as the global economic turmoil again caused a risk-aversion climate among investors. For the quarter ending 30th June 2012, the EIS returned -14.05%. Going into the third quarter, the ETF needed something substantial to happen, in order to restore confidence among investors in this fund amidst its pre-war political intensity with Iran.

Just then, the Fed announced the third round of Quantitative Easing to restore investor confidence in the risky asset classes, a move which led to a rebound in the EIS share price. The ETF returned 10% for the third quarter ending 30th September. Since the announcement of QE3 on September 13th, the ETF has added about 5% (as on 30th September 2012) (read Four ETFs Up More Than 30% YTD).

Having said this, it is also important to note that this by no means is a signal of a trend reversal. Going forward, investor appetite in the fund will be more dependent on Israel’s domestic factors such as political ties with its neighbors and civil peace and harmony within its territories, rather than events surrounding the global economic conditions.

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