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Don’t be caught unawares by bank volatility

FEARS of sovereign debt contagion within the Eurozone have quickly turned into concerns about a European banking crisis. As if investors needed any further confirmation about the fragility of European banks, regional Spanish bank CajaSur was seized last weekend by the Bank of Spain after it had been crippled by property loan defaults.

Plenty of banks – both in Europe and further afield – are exposed to the sovereign debt of Club Med countries. Jacques Cailloux at the Royal Bank of Scotland estimates that there is around €2 trillion of debt issued by public and private sector institutions from Greece, Spain and Portugal held by financial institutions outside of these countries.

The debt crisis is putting a strain on the financial sector and the markets are nervous that European banks still have further bad debts sitting on their balance sheets, says Jane Foley, research director at Forex.com.

But if the financial crisis of 2007-8 taught us anything, it was the sheer interconnectivity of the global banking system – a European banking crisis will therefore not be contained easily.

In such a volatile environment, investors are keen to manage their risks closely and ensure they have sufficient liquidity to jump in and out of the market. Exchange-traded funds (ETFs) are one way for risk-averse traders to gain exposure to the underlying market in what is supposed to be a diversified, transparent and low-cost way.

ETFs can also be bought and sold on the London Stock Exchange (LSE) at any time during market hours and also tend to be very liquid. This is an advantage for ETF traders because it gives them greater flexibility to adjust the asset allocation or implement some tactical strategies.

PASSIVE NATURE
Although their passive nature means you stay exposed to the ups and downs of the market, the diversification required of ETFs under UCITS regulation – for example, there is a limit on how much can be invested in a single stock – means that investors shouldn’t be putting all their eggs in one basket.

But unfortunately, some country-specific ETFs are surprisingly exposed to the financial sector. For example, investors looking for exposure to the mining sector and Chinese growth might well consider buying ETFs based on the MSCI Australia index, such as the iShares MSCI Australia.

But although the ETF’s biggest holding is indeed the mining giant BHP Billiton (13.86 per cent), the financial sector accounts for 46.99 per cent of the holdings compared to 24.51 per cent for materials stocks (see chart).

In this instance, investors interested in Asia’s appetite for natural resources but who want to avoid banks might prefer to look for an alternative ETF. For example, the Lyxor Brazil ETF has a 34 per cent exposure to basic resources and only 10 per cent to financial services stocks.

Even the Lyxor MSCI World TR ETF has a 20.78 per cent exposure to the financial sector, while the S&P Global Financial Index iShares ETF has a 26 per cent exposure to European financial stocks and the SPDR Euro Stoxx 50 ETF has a 29.3 per cent weighting to the financial sector.

This all illustrates the importance of knowing exactly what your ETF gives you exposure to and how it fits in with your trading strategy. For example, Lyxor tells its clients that the underlying index must provide the exposure you are looking for – that is, it needs to be representative of the universe you want to track.

A fund will give you passive tracking of an index but you can, and should be, actively selecting ETFs to build up your portfolio in the way you want. As with any trading instrument, it pays off to take the time to get to know it properly.