Europe Banking ETF Faces Risks

Global equity markets have been confounded by volatility this year, prompting investors seek safe-haven assets. One region that advisors and investors may currently be viewing as somewhat risky is developed Europe, particularly since European Central Bank President Mario Draghi disappointed global financial markets with smaller-than-expected additions and tweaks to the ECB's quantitative easing regime. Since then, European stocks and the corresponding U.S.-listed exchange-traded funds have not been immune to that disappointment.

Down almost 16.1 percent over the past 12 months, the iShares MSCI Europe Financials ETF EUFN could continue facing headwinds due to increased risks in major peripheral Europe banks. That after indexes of European banks offered some out-performance relative to other sectors last year.

“2016 however, has started weakand this is seen by the heightened risk in Europe’s major credit indices. The Markit iTraxx Europe Senior Financials index widened to 96bps last week, just 4bps tighter than at the height of the Greek crisis last July, which threatened to break up the Eurozone,” said Markit in a recent note.

Credit default swaps on debt of Italian bank Monte de Paschi have recently surged, leading some investors to ponder whether or not Italy, the Eurozone's third-largest economy, could become the region's next Greece.

Morgan Stanley recently highlighted the under-performance of European banks relative to the region's inflation expectations. The $254.2 million EUFN features exposure to more than 10 countries, including a 6.2 percent weight to Italy.

“The heightened risk perception in the European banking sector was sparked last month when Portuguese lender Novo Banco was forced to ‘bail in’ select senior bonds by the central bank in order to plug a €1.4bn capital shortfall exposed by ECB stress tests. The possibility of a CDS trigger (which is still ongoing) sent spreads considerably wider. The debacle did little to breed confidence in investors who seem dumfound by the lack of clarity among Banking Union rules,” said Markit.

Seven of EUFN's 11 largest country weights are Eurozone nations and that group combines for over 46 percent of the ETF's weight.

Still, it must be noted that a significant portion of EUFN's geographic weight lies outside the Eurozone. For example, the UK, Switzerland and Sweden combine for about half of the ETF's weight.

“Henderson Global Investors' research said banks were the biggest contributor to an 8.6 percent rise in European dividends during the second quarter of this year. Spanish bank Santander said in September it would look to increase its dividend from 2016 onwards. Italian bank Unicredit also pledged this year to boost its dividend in the future,” according to Reuters.