2 ETFs To Watch On EU Stress Test

European banks will be facing a tough stress test this year to prove their endurance in the bond, property and stock market downturn as well as currency crisis in Central and Eastern Europe. Under this test, 124 banks from the 28-country European Union (EU) have to illustrate their capital strength to counter various economic shocks.

Stress Test in Focus

According to the European Banking Authority (EBA), banks across 28 European nations have to maintain a common Tier 1 capital of at least 5.5% of their risk-weighted assets in order to clear the stress test given the adverse scenario over the three-year period from January 2014 (read: Top European ETF to Play the Portugal Bailout Exit).

The scenario assumes that the EU economy would slip into a two-year recession shrinking 0.7% this year, 1.5% in the next and barely show grow in 2016. Unemployment across the EU would hit a record 13% in 2016; consumer prices will not rise leading to potential deflation; and home, commercial real-estate and stock prices would drop 21.2%, 14.7% and 19.2% over three years, respectively.

Additionally, currencies in Eastern European countries such as Poland and Hungary would devalue steeply and interest rates on government and corporate bonds would rise. Apart from these, banks also have to emerge stronger in the global crisis (read: Where Will Global Currency ETFs Go in 2014?).

The worst-case scenario also predicts that the growth rate in developed economies like U.S. and Japan will shrink by a cumulative 5–6% and fragile emerging nations like China and Russia collectively will plummet 10% over the next three years.

ETFs to Watch

The stress test, which would begin at the end of May, would restore confidence in the banking sector and the broad financial industry, which is the major driver of the economic growth, and prevent taxpayer bailouts. Results will likely be announced by the end of October.

Given this, investors should keep a close eye on the following ETFs and in cash in on the opportunity whenever arises:

iShares MSCI Europe Financials ETF (EUFN.O)

This fund provides exposure to the financial segment of the developed European market by tracking the MSCI Europe Financials Index. It holds 103 securities in its basket with the top two firms – HSBC Holdings and San Banco Santander – taking the largest share at 9.36% and 5.61%, respectively. Other firms do not hold more than 3.84% of assets.

Further, more than half of the portfolio is dominated by banks while insurance and diversified financials make up for a combined 42.6% share. In terms of country exposure, United Kingdom takes the top spot at 30.35% while France, Spain, Switzerland and Germany round off the top five with double-digit allocation (read: Time to Bet on the British ETF?).

EUFN has amassed $507.2 million in its asset base and trades in good volume of nearly 201,000 shares per day. The product charges 48 bps in fees a year and has added nearly 3% so far this year. The fund currently has a Zacks ETF Rank of 2 or ‘Buy’ rating with High risk outlook.

SPDR S&P International Financial Sector ETF (IPF)

This ETF follows the S&P Developed Ex-U.S. BMI Financials Sector Index, holding 135 non-U.S. financial securities of developed countries. The fund is unpopular and illiquid with AUM of $12.4 million and average trading volume of nearly 5,000 shares. Expense ratio came in at 0.50% (see: all the Financial ETFs here).

The fund has a slight tilt toward the top firm – HSBC Holdings Plc. (HSBC.K) – which make up for 4.42% share in the basket. Other securities hold less than 2.8% of total assets. European firms dominate the fund’s return with more than half of the assets, followed by Asia Pacific (35%), North America (13%) and Asia (1%).

In terms of industrial exposure, banks make up for more than half of the portfolio while insurance takes one-fifth share. The fund also has 13% exposure to real estate sector. The ETF is down 2.12% in the year-to-date time frame.  

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