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British ETFs Face Credit Downgrade

Zacks Equity Research

On Friday, Britain was hit as Fitch downgraded the nation’s credit rating by a notch from AAA status thanks to sluggish growth prospects and worries over the country’s debt load (read: Poland: A Better Eastern Europe ETF?).

This is the second rating cut for the British economy this year. In February, rating agency Moody Investor Service downgraded the UK to Aa1 form its supreme AAA rating.

Fitch warned that the country might once again fall into a recession due to its shrinking private and public sector on one hand, and the rising budget deficit and debt level on the other. The agency now expects the UK to grow 0.8% this year and 1.8% in the next from its previous forecast of 1.5% and 2%, respectively.

The British national debt is expected to cross 100% of GDP in 2015–2016, but then decline gradually from 2017–2018. Further, real GDP is not expected to return to the 2007 level until 2014, suggesting that it could still be a while before Britain reaches its pre-recession heights. This underscores the weakness of the recovery, and puts extra pressure on the government’s fiscal consolidation efforts (read: Are UK ETFs in Serious Trouble?).

Despite the fact that the UK has lost its AAA credit rating from two major agencies, it poses an extremely strong credit profile, higher transparency, flexible monetary policy as well as high degree of political and social stability.

However, the ongoing domestic public and private sector deleveraging process and higher-than-projected debt and deficits continue to overshadow the UK economy and impede its performance.

Given this weakness and the lack of catalysts to pull the country out of the malaise, investors who have bet their money in the area must be on the edge. For these investors, we highlight three British ETFs to keep an eye on if this slowdown turns into a dreaded triple dip recession (see more ETFs in the Zacks ETF Center):

iShares MSCI UK Index Fund (EWU)

This is by far the most popular ETF tracking the British economy, as it has roughly $1.5 billion in AUM. Launched in Mar 1996, it is also the cheapest and the oldest equity product for the nation, costing investors 51 basis points a year in fees. The fund is liquid, trading in a volume of 1.2 million shares per day.

The fund tracks the MSCI United Kingdom Index and holds 107 stocks in its basket. It has a definite tilt towards large cap securities, as 80% of the assets accounts for this cap level.

The product does a decent job of spreading assets though, as not a single stock in the basket makes up more than 7.5% of the portfolio. HSBC Holdings (HBC), Vodafone (VOD) and BP plc (BP) are the top three holdings with a combined share of less than 19%.

From a sector look, the fund is also well diversified with financials and consumer staples taking up about 20% and 18% share, respectively. Beyond these, energy (17%), materials (10%), and health care (9%) round out the top five (read: Do Country ETFs Really Provide Diversification?).

The ETF has added 0.28% so far this year and yields a good 3.60% dividend annually. EWU currently has a Zacks Rank of 3 or ‘Hold’, suggesting that the fund will perform on par with the broader markets.

First Trust United Kingdom AlphaDEX Fund (FKU)

Launched in Feb 2012, FKU is the latest fund that provides exposure to the UK stock market by employing the AlphaDEX methodology. This methodology uses fundamental growth and value factors to select stocks from the S&P United Kingdom BMI universe.

Hopefully by using this methodology, and giving higher weighting to more favorably ranked firms, FKU should generate positive alpha relative to traditional passive indices.

In terms of its portfolio, the product is highly exposed to three main sectors – consumer discretionary, industrials and financials – each representing at least 20% share on average. From an individual stock perspective, the fund does an excellent job of spreading out assets as none of the stocks makes up more than 3% of the portfolio, thus preventing a heavy concentration.

The ETF has failed to gain a great deal of popularity though, as its AUM is just $18.6 million and average daily volume is about 6,000 shares. Also, it is quite expensive charging an annual fee of 80 bps on account of its unique methodology. The fund gained 1.32% year-to-date and pays a good dividend yield of 2.15%.

This fund currently has a Zacks ETF Rank of 3 or ‘Hold’ as well.

iShares MSCI United Kingdom Small Cap (EWUS)

EWUS is another product tapping the U.K markets. It was launched in Jan 2012 and seeks to match the price and yield performance of the MSCI United Kingdom Small Cap Index, before fees and expenses. The index measures the equity performance of small cap companies, the market capitalization of which represents the bottom 14% of the UK equity markets (read: Small Cap Japan ETFs: Overlooked Winners?).

The fund holds 248 securities and puts less than 14% in the top 10 firms. EWUS allocates its assets uniformly across all securities ensuring that concentration risk is nearly diversified away. The ETF can be a good tool for investors looking for European exposure for their portfolio and at the same time allow them to play a UK recovery as well.

The fund is skewed towards consumer discretionary with about one-fourth of the portfolio, closely followed by industrials and financials with a combined share of 39%. Other sectors make a nice mix in the portfolio. The product has amassed $4.8 million in its asset base and has a wide bid/ask spread thanks to its relatively illiquid nature. It charges 59 bps in fees from investors a year.

Given its small cap bias, the ETF is expected to outperform the broader markets in case of an economic recovery, as small caps outperform their large and mid cap counterparts in times of recovery. The fund is up 4.71% in the year-to-date time frame with paltry yield of 0.99%.

However, investors should also remember that small caps generally underperform during long periods of market weakness. This could be the case in the months ahead if Britain continues to struggle, so EWUS could be thought of as a higher risk, higher reward play on the British ETF market.

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