Brexit Prep With ETFs

If not for a 3.3 percent year-to-date decline for the exchange traded fund that acts as a proxy for the U.S. Dollar Index, the CurrencyShares British Pound Sterling ETF FXB would be a dud among developed market currency ETFs.

In fairness to the CurrencyShares British Pound Sterling ETF, its 1.8 percent year-to-date loss is relatively tame with all the attention “Brexit,” or Great Britain's potential departure from the European Union, is receiving. By some estimates, if Brexit comes to pass, sterling could tumble 20 percent.

While FXB has been sturdy in the face of Brexit speculation, the same cannot be said of the iShares MSCI United Kingdom ETF EWU. EWU, the largest New York-listed U.K. ETF, is down 12 percent year-to-date. Though the odds of a Brexit are somewhat low, there are ways investors can prepare for the worst-case scenario.

“The UK's EU referendum presents a key risk to UK (and global) investors in 2016. The referendum is likely to be near-term, probably in late-June (23rd or 30th) and the outcome is uncertain. Our economists continue to put the probability of Brexit at around 20-30%, so it is not our base case but by no means a trivial risk. The effects of Brexit, if it happens, are likely to be large and painful in economic and political terms, both for the UK and the EU as a whole. Brexit could trigger significant economic weakness for the UK, with a 15-20% depreciation of sterling in trade-weighted terms, resultant return to import-driven inflation and a major policy dilemma for the MPC,” said Citigroup in a note out this week.

The bank suggests several Brexit hedges, including overweighting energy names relative to financials. EWU allocates 21 percent of its weight to the financial services sector and nearly 13 percent to energy names. There is risk in overweighting European energy names, namely a murky dividend outlook for the U.K.'s benchmark FTSE 100, which, though it has yet to, could eventually ensnare BP Plc BP and Royal Dutch Shell Plc (NYSE: RDS-A). Both are top 10 holdings in EWU.

Citigroup also advises overweighting pharmaceuticals, mobile telecom, tobacco and household goods stocks relative to U.K. food and non-life insurance names. The consumer staples sector is EWU's second-largest sector weight at 20.4 percent.

Investors bold enough to bet that Brexit could eventually lead to upside for U.K. stocks while suppressing sterling should look at the Deutsche X-trackers MSCI United Kingdom Hedged Equity ETF DBUK. Roughly half of DBUK's combined weight is allocated to the consumer staples, energy, healthcare and telecom sectors.

“While some of this would present stiff headwinds for UK equities, a sharply weaker GBP has tended to be supportive of UK share prices in GBP, if not USD, terms. It helps that UK plc only derives c30% of sales and profits from the UK. The global economy and commodity prices likely hold greater importance for UK share prices in the next 12-18 months than Brexit,” said Citi.