Investing With British ETFs

| About: iShares MSCI (EWU)

Summary

Following the Brexit decision, many investors have considered playing the recent decline in major British stocks to capture short-term returns.

This strategy of picking individual stocks underperforms the broader market historically, thus investors should consider ETFs as an available alternative to pursue a similar investment strategy.

Through a fundamental and technical analysis, the top three British ETFs are evaluated in order to determine the different investment options available to readers.

Following June 24th's historic decision which saw British citizens marginally approve the nation's EU referendum, UK markets lost a reported £125 Billion in asset value over the past two weeks amounting to a "combined 15 years of EU contributions." The aftermath of the Brexit has been challenging for speculators as British and European related equities continue to sell off in the face of persistent news coverage relating to the uncertainty of the country's future. While North American markets have begun to find their footing, British stocks continue to sell off as the nation remains directionless following the resignations of key leaders. In light of this collapse in the world's fifth largest economy, many global investors and Seeking Alpha members have adopted a contrarian view on some of the major British stocks which have seen significant declines in their share price. Unfortunately, there are many questions that remain unanswered when considering the economic outlook for the nation and the changing fundamentals forced upon these respective companies. Even in a situation where these fundamentals remain strong, investors have seen many instances of stocks remaining lower due to bearish sentiment surrounding their economic exposure or related industry. Therefore, while this decline may have fueled some unwarranted discounts in British-related equities, picking individual companies in expectation that they will recover is not the best investment strategy when considering the fragile outlook for the UK.

The more stable and accurate option in order to play a potential recovery is to purchase exchange traded funds also known as "ETFs". Instead of investing in one company and risking exposure to the uncertainty of how its fundamentals will change in the longer-term, buying the market itself is the much safer option. For investors who have the risk tolerance to play the decline in the UK market, investing with ETFs offers the best option to profit from any recovery while also hedging against the downside risks that come from investing in one stock versus a basket of equities.

Market Outlook

Before making an investment decision regarding which ETF to employ, it is important for investors to properly appreciate the risks that have come with the Brexit decision. When considering the country's relative situation earlier this year to other EU nations, the UK found itself in a much stronger economic position. The unemployment rate was at 5% reaching pre-recession levels while strong increases in the labor force participation rate confirmed this strength in the labor market. In addition, wage growth has been strong in the past year following the decline seen in 2014 as the country continues to benefit from growth in the service sector. The problem with focusing on these economic indicators is that much of this strength is tied to the stabilization efforts of the EU through the quantitative easing program and further policy intervention. Once the country moves forward with its exit strategy and becomes less dependent on the union, the market outlook is far more uncertain as economists forecast major fundamental changes in the market.

Focusing on the potential challenges that may be amplified through this breakdown in political and economic relations, the pressures of lower oil and limited growth in the EU should impact the outlook for inflation and GDP expansion. The UK reported a drop in quarterly GDP to 0.4% in Q1 and if the country does leave the EU, the economic uncertainty surrounding the newly "re-signed" treaties makes projecting any future GDP growth much more difficult. With the domestic currency falling by 12% against the USD in the past month, UK businesses have experienced a dramatic shift in pricing strength as exports become temporarily cheaper while the longer term cost of importing increases significantly. The uncertainty surrounding the growth and future of British trade is another challenge which only further clouds the country's outlook. For readers considering investment exposure to the country, the best response to the uncertainty surrounding the economic outlook is to extend their investment horizon.

Investment Options

When considering the available ETFs, it is important to determine the types of investment styles they are tailored for by applying three criteria. These considerations are; (1) the fund size, also known as net assets (2) the volatility of the ETF's market price, and (3) the allocation strategy. The larger an index fund is, the broader the capital allocation strategy can be in order to properly capture the performance of major markets like the UK's FTSE 100 Index (UKX). The liquidity of the fund is important in determining whether there is sufficient inflows of capital to increase investment demand and portfolio size. Lastly, the allocation strategy reveals whether the fund invests in small caps or large caps; or whether the fund is able to deviate from the respective weights of the index it is intended to match.

With regards to a British investment strategy, the top three index funds available are; the iShares MSCI United Kingdom ETF (NYSEARCA:EWU), the iShares MSCI United Kingdom Small Cap ETF (BATS:EWUS), and the First Trust Exchange Traded AlphaDEX Fund II (NASDAQ:FKU).

iShares MSCI United Kingdom ETF

The iShares products have always been one of the premier index funds available to retail investors due to the strong net asset value and consistent trading volume. The EWU ETF confirms this brand strength with a 1 month average volume of 6.8 million trades, a net asset value of over $1.942 billion USD, and a equity beta of 1.02. The fund is down by -19.04% yoy and when excluding the last three weeks, thus removing the Brexit impact, the fund was down by -10.83% yoy. The fund provides exposure to large and mid-sized British companies with a targeted access of 85% to the UK market (current exposure is 98.99%). EWU's top 5 holdings are; British American Tobacco (NYSEMKT:BTI), HSBC Holdings (NYSE:HSBC), Royal Dutch Shell (NYSE:RDS.A), BP (NYSE:BP), and GlaxoSmithKline (NYSE:GSK); which each make up 5.4%, 5.26%, 5.09%, 4.82%, and 4.61% of the total portfolio respectively. The top 5 sectors are; consumer staples (20.8%), financials (17.95%), energy (14.61%), health care (11.49%), and consumer discretionary (9.02%).

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^Author's Work

When looking at the major holdings, companies like British American Tobacco, BP, and Royal Dutch Shell all have majority of their operations spread out globally. When considering that revenues are reported in UK Sterling, the current drop in the domestic currency will allow these companies to book marginal gains as the pound becomes weaker. In addition, because operations are spread out globally, the impact of any negative breakdown in EU relations should not have a significant impact on the bottom line. Conversely, a much broader impact stemming from the Brexit will be the drop in confidence surrounding many of these British-related equities as slow growth in the past several years has hurt country-specific expectations. When breaking down the impact of these multinational holdings, the 1-month average for EWU's top 5 holdings is 3.59% which indicates that majority of the fund's decline has originated from its much lesser-weighted equities which hold more domestic exposure. For interested investors, this remains the top ETF option when considering exposure to British markets and if the country's market does find stability, EWU provides a strong option to capture the possible recovery.

Ishares MSCI United Kingdom Small Cap

Another segment of the iShares product line is the small cap options available to retail investors. The small cap space has been most heavily impacted by the Brexit as illustrated by the 5.68% decline in the FTSE Small Cap Index (SMX) in the first week following the referendum. Due to heavy domestic exposure from majority of these small caps, their inability to expand internationally without major cost impacts weakens the outlook for the sector. This product is more of a speculative tool available to investors which can offer a shorter timeline to profit off any positive developments in the market. From a longer-term perspective, if the country does initiate article 50 to leave the EU, these small caps will experience a major shift in the business landscape which will require a major cost and cultural investment in order to recapture growth. When considering the EWUS product, it's a very different investment compared to the much larger EWU fund discussed earlier. With net assets of only $17.27 million and a 1 month average volume of 31,621, the low liquidity makes it more difficult to trade in and out of. Thus, while the product may be a useful speculative tool for the shorter term, this low liquidity could pose some risks to exiting positions. Following the Brexit announcement, the ETF fell by 29.9% in the span of two days and saw an all-time high in trading volume which puts EWUS' 1 year performance at a -26.45% decline.

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When considering the fund's portfolio, the top 5 holdings are Informa (OTC:IFPJF), Halma (OTCPK:HLMAF), Pennon Group (OTCPK:PEGRF), DS Smith (OTC:DITHF), and Rentokil Initial (OTC:RKLIF) which each make up 1.99%, 1.59%, 1.55%, 1.51%, and 1.51% of the portfolio respectively. Due to the portfolio's focus on the small cap space, each holding has a limited amount of exposure confirmed by the sub-2% weightings from the fund's top equities. From a sectoral view, the portfolio's top 5 sectors are financials (22.93%), consumer discretionary (20.78%), industrials (19.56%), information technology (11.62%), and materials (7.19%). Compared to the larger EWU fund, the higher financial exposure in addition to the uncertainty that comes with the small cap space does raise some questions regarding the performance of these equities following the referendum. Investors should understand that the iShares small cap index is more of a trading tool to capture volatility rather than a longer-term investment vehicle. Pairing the EWUS and EWU products offers a better option in playing the longer-term growth of the small cap space while being supported by the more consistent performance of large cap holdings.

First Trust Exchange Traded AlphaDEX Fund II

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The First Trust Exchange Traded AlphaDEX Fund II is a more unique ETF as it employs the AlphaDEX stock selection process which rebalances the portfolio on a semi-annual basis. AlphaDEX uses a Nasdaq constructed UK index where the fund seeks to produce similar correlations and risk characteristics to the broad market while seeking outperformance due to selection and weighting strategy. Another important consideration is that AlphaDEX funds are classified as "non-diversified," meaning that the portfolio can allocate a larger percentage of its assets to more focused weightings thus increasing overall risk due to this heavy exposure. In general, the allocation strategy for ETFs focuses on matching the sectoral weighting of their targeted indexes thereby capturing market performance. For the FKU fund, the weighting constraints are set at 15% above the benchmark weighting which means that the fund can invest over 30% of total capital in the oil, financial or industrial sector while maintaining its index-fund classification. This ability to rebalance its weightings to higher than normal levels can be seen by the heavy exposure shared in its top 5 sectors; financials (28.9%), consumer discretionary (24.4%), industrials (15.61%), information technology (11.81%), and materials (8.14%). While FKU shares a similar sectoral composition to the EWUS product, the portfolio holds over 50% of capital in the financial and consumer cyclical sectors which raises questions of beta-focused exposure.

Whereas the top 5 holdings of the EWU fund were inline with the top constituents of the FTSE 100 index in order to match market performance, the FKU held none of these equities in their top 10 holdings (25.47%). This ability to deviate from index weightings due to its "non-diversified" status is a major consideration for investors who use the product. This stock selection process results in both a lower market beta, higher volatility, and less accuracy in capturing the performance of UK markets. For investors who may consider the FKU fund, its non-diversified classification can be paired with a more market focused ETF like the iShares EWU to capture stable growth opportunities in the broader domestic economy.

Putting Things Into Perspective: Technical Analysis

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^Sourced from Yahoo Finance

Another major difference between the three index funds is the relative age of the products and their historical performances through different economic events. Both the AlaphaDEX fund and iShares Small-Cap Index were started in 2012 following the financial collapse so there is limited historical data to compare to the Brexit's impact. Luckily, the EWU iShares fund is much more senior having been released in 1996 thus providing the ideal timeline to compare the market's recent reaction. When analyzing the fund's historical share price performance, it is clear that the Brexit impact is more of a news event rather than a development which fundamentally changes the trajectory of the fund. When considering the three ETFs, investors can employ technical indicators like the money flow index ((NASDAQ:MFI)) and relative strength index (RSI) to determine shorter term trends.

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From a technical perspective, the iShares MSCI United Kingdom Small Cap ETF, shows very bullish signs as both the 50-day MFI and RSI indicators are below their historical averages, medians, and lowest quartiles. When employing a Z-distribution, the stock currently finds itself at a very extreme -2.4 score which means that the fund is heavily oversold based on historical terms. While the fund is much newer than other options which can limit the accuracy of a technical analysis, it is clear that the product, relative to the past several years, offers value for more risk-oriented investors. With the increased volatility seen in the fund, investors can look to enter quickly and use the ETF in a shorter-term strategy based on these bullish technical indicators.

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Similar to the iShares Small Cap ETF, the First Trust Exchange Traded AlphaDEX Fund II is another product that has entered oversold territory in the past few days. Due to the fund's non-diversified status which allows for more focused exposure, the volatility of its indicators are much higher than other large cap funds. Looking to the equity's Z distribution, the recent -1.81 score was the lowest in the product's history confirming that the Brexit reaction was statistically extreme. In addition, both the MFI and RSI indicators were lower than their respective averages, medians, and 50th quartiles. It is important to note that the most recent MFI index of 38.49 was above its 25th quartile meaning that based on the historical population, there were several times when the MFI fell much lower than the current level. It's difficult to consider the value of such an indicator due to the fund's non-diversified status and high standard deviation however the general strength of all indicators communicates that the ETF is oversold. With its large cap exposure providing more fundamentally stable holdings, the AlphaDEX Fund could offer a much longer term play on the recovery of UK markets.

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Returning to the much older iShares large cap UK ETF, the fund illustrates a much different picture when considering its historical indicators based on full 20 year averages. With a MFI index of 55.53, the indicator is above its average, median, and lowest quartile by an incremental margin. In addition, the 55.53 MFI level is significantly higher than the other two indexes confirming that relative to the longer-term horizon, the Brexit is much less impactful than market pundits have communicated. While the ETF is not expensive in relative terms, a Z-score of only -0.62 confirms that the price reaction in the past few weeks is not considered extreme. Therefore, when putting the recent EU referendum in perspective to larger economic events like the tech bubble or financial collapse of 2009, investors get a better understanding of the magnitude of this event. Technically, the fund remains fairly priced in the current market thus investors should only consider the ETF if markets worsen or their respective investment horizon lengthens.

Conclusion

Historically, investing with ETFs has accurately captured the full performance of domestic economies while also providing reduced exposure to volatility due to a diversified portfolio of assets. When considering the recent Brexit events which have sent British markets into turmoil, the urge to pick individual stocks in a very uncertain market remains a poor speculating habit for investors. The more profitable option is to use index funds like the three analyzed above in order to capture the desired exposure to any potential recovery in the UK market. For investors who are bullish, combining the accurate exposure and diversified holdings offered through these suggested ETFs will allow for the safest investment strategy in the current market.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.