Spain: better to be safe than sorry

IT IS still too soon to say whether the Spanish government’s austerity budget will be enough to calm the markets and quell fears that an economy twice the size of Greece, Ireland and Portugal combined will need a bailout.

But even if the legislation does resolve Spain’s problems, exchange-traded fund (ETF) investors with exposure to Europe still need to be concerned. While it is extremely important that Spain sorts out its public finances, the real crisis for investors lies in the health of the Spanish banking sector.

Safe in the knowledge that Spain only makes up a sliver of their exposure to Europe, investors might be less on edge.

However they should not rest so easy. The chart to the right shows the levels of international investment in Spanish banks. Europe as a whole could take a substantial hit if the Spanish banks do not take action on the bad loans made to the construction industry during the housing market bubble.

Morningstar data shows that there are 23 ETFs offering exposure to European financials with combined total net assets under management close to €1.7bn. All of these funds could suffer quite substantially if the Spanish banks were to come under fire.

These ETFs have exposure in different ways. Nine of the 23 are tracking indices offering exposure to European banks (accounting for 67 per cent of net assets); eight are tracking indices exposed to insurance stocks (accounting for 7 per cent of assets); six are tracking indices exposed to the whole financial sector – both banks and insurance – which accounts for the remaining 27 per cent of assets.

Ben Johnson, Morningstar’s director of ETF research says that if the crisis were to occur, these ETFs will be at the very epicentre of the crisis and will suffer severely. He strongly urges investors to examine the sector breakdown of their Europe ETF to avoid any nasty surprises: “So often you see people treating their ETFs like cans they pick off the shelf in the supermarket. They don’t read the label, so they end up getting something very different from what they thought they put in their cart.”

While the problems of the Spanish banking sector are not as extreme as those recently experienced in Ireland, the market operates in tunnel-vision, boorishly focusing on one problem at a time. Should it turn to Spain, the banking sector will no doubt feel the hit.

There are methods, however, for hedging against this. José Garcia-Zarate, a European ETF analyst with Morningstar, says: “The obvious first port of call would be to roll out a short Spain strategy, choosing Spanish-centric equity ETFs such as the BBVA Accion Ibex 35, Amundi MSCI Spain or Lyxor Ibex 35.” These are all heavily exposed to the banking sector.

While we can’t know yet whether the market will turn its attention to Spain’s troubles, or how the Eurozone crisis will play out in 2011, investors with European exposure should examine the sector breakdown of their ETF carefully, looking closely for European financials – just in case.