Beyond Poor GREK

May 25, 2012

European officials have been kicking the can down the road for years. But it seems like that road is ending sooner rather than later. Investors beware.

The future of the euro looked less bright since May 6, when Greek political parties opposing the terms and conditions of the second bailout were voted into office.

Because, despite public support, Greek parties failed to form a government and the next elections are being held on June 17. Unsurprisingly, the Global X FTSE Greece 20 ETF (NYSEArca: GREK) has been a staple recently on our “Best/Worst Daily ETF Returns.”

GREK is, in my view, just the tip of an iceberg, and it’s really time for investors to get focused on how to control potential damage.

I realize some argue that Greece’s departure from the eurozone may strengthen the remaining nations in the European Union, and that may be true.

But it could also do the opposite. It may weaken the idea of the euro and serve as a precedent for others to exit.

After all, Greece is just one of the letters in the by-now-familiar “PIGS” acronym – the others being Portugal, Italy and Spain.

I mindfully changed the term to "PIGS" from the original “PIIGS”—the second “I” representing Ireland, which in many ways has passed through the worst of its banking crisis, as my colleague Ugo Egbunike wrote in a story last week on the fate of the euro in this whole mess.

Wanted: Eurozone Exit Plan

Officials have tried hard to fix the European debt crisis, since a failure to do so may wreak havoc on financial markets worldwide.

But another key aspect in influencing their procrastination is the fact that an “exit plan” was not built into the policy. Joining the EU was meant to be a one-way road. So now, even if European leaders decide that a “Grexit” is inevitable, there’s no policy in place for the country to do so.

It doesn’t matter anymore that the eurozone’s architects failed to meaningfully consider the possibility of today’s mess in southern Europe.

All that matters now is that today’s leaders come up with a plan. And if that plan involves Greece’s exit, then it could set a precedent for others.

Italy and Spain, both dubbed as the “next Greece,” have much larger economies than Greece, and their exit would affect the eurozone and the global economy to a much greater extent.

How long will it be until financial markets and European officials turn their attention to other nations that have high government deficits and low economic growth?

I don’t have a crystal ball, but data does show that Greece is not the only piggy playing in the mud.

From the chart below, you can see that Portugal, Italy, and Spain are much weaker than Europe and the eurozone as a whole. This shouldn’t be surprising, since both are supported by governments with much healthier balance sheets, such as Germany.

 

Country Indexes

Source: Bloomberg

 

Although Portugal, Italy and Spain aren’t in the news today, that doesn’t mean that they won’t be tomorrow.

With such a possibility in mind, there are a handful of country-specific eurozone equity ETFs that investors should be keep an eye on.

 

 

The funds are:

  • Global X FTSE Greece 20 (NYSEArca: GREK)
  • iShares MSCI Spain Index Fund (NYSEArca: EWP)
  • iShares MSCI Italy Index Fund (NYSEArca: EWI)

 

Admittedly, GREK, which launched fairly recently, has a shallow fund asset base—$2.5 million. However, EWP and EWI show much stronger investor interest, with assets of $140 million and $127 million, respectively.

If things head south, investors in risky country-specific ETFs may suffer greater losses than those market players that diversify across all of Europe.

And in case things get a whole lot worse before they get better, even those not invested in country-specific ETFs should hedge their positions.

Besides shorting securities, investors can also utilize inverse currency ETFs and ETNs.

Two possible choices include the ProShares UltraShort Euro ETF (NYSEArca: EUO) and the Market Vectors Double Short Euro ETN (NYSEArca: DRR), which have both done well for those holding them in recent months.

EUO returned 18.72 percent, while DRR returned 19.79 percent, whereas EWP and EWI lost 37.56 percent and 38.73 percent, respectively.

A broader Europe ETF, such as the Vanguard European (NYSEArca: VGK), served investors slightly better, but still wound up in the red at -18.63 percent.

 

Hedge Options

Source: Bloomberg

If investors don’t want to expose their portfolios to counterparty risk from ETNs or tricky inverse funds, they could cushion their exposure to Europe by choosing a fund with a higher percentage of assets allocated to stronger economies.

This may require diversifying away from the eurozone, but that may not be such a bad thing.

Investors can find a European ETF with maximum EU exposure without the PIGS.

Two funds that come to mind are the SPDR Stoxx Europe 50 ETF (NYSEArca: FEU) and the iShares S&P Europe 350 (NYSEArca: IEV). Although these funds won’t totally steer clear of disaster, they will allow investors to retain exposures in the region with minimal drag from EU’s weakest economies.

I’ve just scratched the surface on how broad Europe-focused ETFs can help investors negotiate the increasingly dire straits. So I’ll circle back next time and fully develop that line of defense.

 

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