Stress-Test Your ETF Portfolio

July 20, 2011

With all the debt-related uncertainty in Europe, now’s as good a time as any for investors to stress-test their ETF portfolios.

As Carolyn pointed out a few weeks back, you can have exposure to the European debt crisis in ways you never thought imaginable. Her analysis, while worthwhile, looks outdated, as the creditworthiness of Italy and even Spain are now coming into question. And, as Carolyn pointed out, portfolios owning European government bonds are obviously at risk, but that’s just the tip of a nasty iceberg.

Any real European contagion will adversely impact European banks, insurance companies and corporate earnings. In fact, according to an article the Wall Street Journal published this week, total commercial and industrial loans to the so-called PIIGS—Portugal, Italy, Ireland, Greece and Spain—by European banks is in excess of $5 trillion.

That means funds like the SPDR Euro Stoxx 50 (NYSEArca: FEZ) or the Vanguard MSCI European (NYSEArca: VGK) are at risk in a period of protracted market weakness. After all, 27 percent of FEZ is in financials, giving investors significant exposure to EU government debt. FEZ’s price has fallen about 6.5 percent since the beginning of July, according to data compiled by Bloomberg.

Moreover, it’s not just funds tracking broad European indexes that carry European exposure risk.

For example, Europe makes up a significant portion of developed country funds such as the iShares MSCI EAFE Index Fund (NYSEArca: EFA). It has 23 percent exposure to financials and 57 percent to Europe. It’s a $38 billion ETF, meaning that should things go terribly wrong, a lot of people would be affected. For now, EFA is down 2.3 percent in July and 5.5 percent in the past three months.

Global total market funds present the same risks, though probably not to the same degree as fund like EFA.

The iShares MSCI ACWI fund (NYSEArca: ACWI), for example, has more than 20 percent exposure to Europe, with over 19 percent of the portfolio’s assets in financials. If you’re concerned about Europe’s debt woes, your global large-cap exposure is likely right in the middle of the continent’s debt vortex. ACWI has dodged the eurozone crisis so far this month, with a 1.1 percent gain, but it has fallen almost 2 percent in the past three months.

Another piece of this stress test has to do with low interest rates in the U.S., which has sent investors looking for yield in the equity space. Unfortunately, this search for yield can also expose investors to significant European risks as well.

The WisdomTree International Large Cap Dividend Fund (NYSEArca: DOL), for example, has more than 65 percent exposure to Europe with 24 percent of the fund’s assets invested in financials.

Should restructuring or actual defaults occur, Europe’s big banks will be faced with write-downs, something that could have a direct impact on their ability to pay dividends. Haircuts on the debt will lead to haircuts on equity valuations and dividend yields, a nasty consequence for investors in these funds. DOL, for the record, has declined almost 4 percent so far this month.

Threats to your portfolio don’t end there. It may seem obvious that ex-U.S. financials funds like PowerShares KBW International Financial (NYSEArca: KBWX) are highly exposed to Europe’s financial giants; after all, the fund is down over 8 percent in the past three months, but other niche funds carry similar risks.

Global real estate funds like Vanguard’s Global ex-U.S. Real Estate (NasdaqGM: VNQI) are the perfect example. Should the weakness of the European economy put pressure on commercial, industrial and retail property prices and rents, European REITs will be priced lower by the market in short order. It’s about unchanged year-to-date, but it has serious downside potential if things unravel in the EU.

Nothing I’ve laid out here is original, but I hope that illustrating how many pockets of the financial world could be affected by Europe’s problems will help investors understand risks that global investment have at this critical juncture.

In the end, global large-cap exposure is increasingly at risk as Europe’s debt crisis comes to a head, and it’s crucial that investors take the proper steps to protect themselves, or at least know what could be in store.


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