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Are UK ETFs in Serious Trouble?

Eric Dutram

Stock prices have broadly risen across Europe as the continent’s crisis has been put on the back burner for the time being. However, we could be entering the second leg of the crisis as some of the region’s largest and, until recently, strongest economies are starting to buckle under the pressure.

First, investors saw the ultra-strong German market face some weakness, and now it appears as though the UK is once again in the crosshairs. The country recently reported fourth quarter GDP figures, leaving much to be desired over the country’s short-term health.

In the report, GDP for the country slid by 0.3% over Q3’s figures, falling much further than the economist estimate which called for a contraction of 0.1%. Now, with predictions of another contraction coming for the first quarter, there is a very real possibility that the UK could face a triple dip recession (read UK ETF Investing 101).

Obviously, this prospect isn’t great news for the British economy and it is causing some to demand an end to the nation’s somewhat controversial austerity program. The government has vowed to continue it though, so the nation will have to hope that the long term benefits of the program outweigh the short-term pain.

Currency Impact and Outlook

If that wasn’t enough, investors should also note that the pound is sliding against its developed market counterparts, falling to its lowest level in more than a year against the dollar and the euro. 

While this is normally a welcomed situation for exporters, some fear a fresh bout of inflation which could cancel out any benefits from the lower currency, especially in a nation that relies so much on imports for many key products.

This trend along with the weak outlook suggests that Britain may be in for some more pain and that their Olympic-induced boom is definitely over (read Play Europe with This ETF Pair Trade).

"While we believe the economy is essentially flat at the moment, it is worrying to note that GDP in the fourth quarter of 2012 was 3.3 percent below the peak level seen in the first quarter of 2008.’ said Howard Archer, chief U.K. economist at IHS Global Insight in a research note.  “We suspect that GDP will not return to the level seen in the first quarter of 2008 until the first half of 2015 – a gap of seven years."

Given this ongoing weakness and the lack of catalysts to pull the country out of the malaise, investors who are invested in the area should be on edge. Below, we highlight some of the UK ETF options which should be closely monitored as a barometer for the country’s economic performance should this slowdown turn into a triple dip recession:

iShares MSCI UK Index Fund (EWU)

This ETF is by far the most popular tracking the British economy, as it has over $1.4 billion in assets. The fund is also the cheapest and the oldest equity product for the nation, costing investors 52 basis points a year in fees.

The fund is pretty well spread out across segments, with financials and energy each taking up about 20% each. Beyond these, consumer staples (17%), basic materials (12%), and health care (8%) round out the top five.

In total, the ETF holds just over 100 stocks in its basket, with a heavy (80%) focus on large cap stocks. It does do a decent job of spreading out assets though, as no one security makes up more than 8% of the portfolio (see 4 Excellent Dividend ETFs for Income and Stability).

This fund currently has a Zacks ETF Rank of 4 or ‘sell’, which means that we are looking for underperformance in this product this year.

First Trust United Kingdom AlphaDEX Fund (FKU)

In a distant second for equity ETF assets is this quantitative-based ETF from First Trust. The fund tracks the Defined UK Index, and charges investors 80 basis points a year in fees for its exposure.

This approach results in drastically different holdings set, as consumer discretionary (24%), industrials (19%), and financials (17%) take the top three spots. The method also tries to eliminate the worst ranked stocks based on a variety of growth and value metrics, so hopefully a better portfolio is realized with this ETF (see Three European ETFs That Have Held Their Ground).

However, the cost is obviously higher, while the bid ask spreads also are wider suggesting higher total costs for this ETF. Still, the product does an excellent job of spreading out assets as no one stock makes up more than 2.5% of the portfolio.

This fund currently has a Zacks ETF Rank of 4 or ‘sell’, which means that we are looking for underperformance in this product this year.

CurrencyShares British Pound Sterling Trust (FXB)

For a currency play on Great Britain’s situation, investors should consider FXB. This product has a decent level of assets-- $70 million—while charging a low 40 basis points a year in fees.

The fund tracks the price of British Pound Sterling net of expenses, which are paid out from interest earned on the deposited currency. The product can be thought of as a lower volatility way to play the British economy, but one that will probably not be able to produce excessive—either positive or negative—returns either.

It should also be noted that while it isn’t the most traded product, it does offer up a relatively tight bid ask spread. This is thanks in part to the extremely liquid market for British pound sterling which helps to keep total costs around the stated expense ratio (read Beyond the PIIGS, Three Troubled European ETFs to Watch).

Currently, this fund has a Zacks ETF Rank of 3 or ‘hold’ suggesting an in line performance for this currency over the next year.

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Read the analyst report on FXB

Read the analyst report on EWU

Read the analyst report on FKU

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