Looking Past The Anarchy In The U.K. With ETF Opportunities

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Ask the average investor for their opinion on British stocks and the first thing that comes to their mind is likely to be the old Sex Pistols song, “Anarchy in the U.K.” And why wouldn’t they think that, after several years of progressively more negative media coverage as former PM Theresa May tried to arrive at a negotiated settlement, followed by a period that can only be described as a “feeding frenzy” after the arrival of Boris Johnson at 10 Downing Street. In his just over two months in office, Johnson has been soundly defeated in Parliament, accused of lying to the Queen and rejected by his own brother and fellow MP. Anarchy in the U.K., indeed!

No doubt that sort of publicity made some remember that old investment chestnut to buy when there’s “blood in the streets,” but speculators hoping for good values have been disappointed by the all-too-predictable fallout. British-oriented ETFs underperformed their broader EU zone and American peers, leaving those hopeful speculators with a serious case of buyer’s remorse.

The culprit has been a wildly vacillating pound that is down versus the dollar to the lowest levels of decade, before recovering based on some new hopeful outlook for Brexit negotiations. Great for traders, not so much for investors.

Even with the constant drumbeat of negative press as the Johnson government lurches towards disaster, a surprising trend has emerged as the two primary U.K.-oriented ETFs, the iShares MSCI United Kingdom ETF (EWU) and the much smaller First Trust United Kingdom AlphaDEX ETF (FKU), have seen their ETFG Quant scores begin to rise, with FKU making our list of top scorers. Does that signal the start of a new trend, or are investors falling for another case of “This time it’s different?”

Quant Update

Regular readers will already be familiar with our quantitative model where we analyze and rank thousands of ETFs every day using dozens of different indicators to help identify emerging trends. It helps to view our rankings under a series of broad combinations, including behavioral, which includes price momentum and sentiment, and fundamental, which compares the current price multiples to historical values. Both can be highly informative under the right conditions, but it’s in the behavioral arena where we’re seeing the strongest showing for those British funds.

Looking at our list of top 25 highest-scoring funds ranked by behavioral metrics brings up a mixed bag of products and themes, including healthcare, energy and thematic funds, but ranked at #8 is little FKU, which owes its spot to a combination of factors. First, there is the steady, if not amazing, price momentum, measured across a variety of different time frames to rule out any short-term blips. A price chart might be more informative than our ETFG scores, where you can see that not only has FKU gone from oversold to overbought on a short-term basis, but the fund has also managed to push out of the downtrend channel that’s held it back since early April.

Shifting our focus to a longer-term chart shows a similar pattern, with FKU escaping the downtrend last week, and while the fund closed near its low last week, it remains above the prior downtrend.

Any number of other British funds, including EWU or the hedged equivalent, the iShares Currency Hedged MSCI United Kingdom ETF (HEWU), have similar chart patterns and performance figures for last week – which, given their bigger size (by market capitalization), makes their scores even more impressive. So why is FKU ranked near the top of our list, while EWU is lucky to break the top 50%?

The key difference, at least as far as our quant models are concerned, is in our sentiment scores, which take a contrarian approach by looking at indicators such as implied volatility, short interest and the put/call ratio, and this is where FKU really shines. Not only does FKU have a short interest ratio in the upper decile of its historical range, but the fund is also far more volatile than its larger peers. This is due to the relatively small size of the fund, both in terms of its total assets at a mere $9 million compared to $2 billion for EWU and also the size of the companies it invests in which are typically much smaller than EWU.

Climbing to the top of our behavioral quant model requires having both momentum and contrarian factors working in your favor, but any kind of quantitative ETF analysis can quickly devolve into a situation best described as “missing the forest for the trees.” Sticking to predefined factors, or the obsession to seek out new ones, can blind investors to the simple truth of what’s really driving a fund’s returns. And in the case of FKU, it’s a simple story told repeatedly but never really learned, the situation isn’t that bad as you might think.

Behind the Media Curtain

That’s not to say that Brexit hasn’t been a total nightmare or that the United Kingdom won’t avoid a hard crash out of the EU at the end of October. There exists a very real potential for the country to find itself in the midst of a massive, self-inflicted recession that could tear the nation to shreds, but that story has been beat mercilessly into the average media consumer’s ears for several years now. And the effects of that coverage have been predictable, with the largest U.K.-only ETFs available in the US drastically underperforming. Just look at this table with the primary U.K. funds up paltry amounts since the Brexit vote was completed compared to both the iShares MSCI Eurozone ETF (EZU), the iShares MSCI EAFE ETF (EFA) and, of course, a domestic fund like the SPDR S&P 500 Trust ETF (SPY).

But 2019 has been a very different story, with FKU outperforming this comparison group and coming within grasping distance of SPY. Even more impressive is that FKU is actually outperforming the rest of the group since July 24^th. Why that date? It’s when Boris Johnson assumed office as Prime Minister. Does that mean British investors are raising their expectations (and the share prices) of British stocks going forward?

Possibly, in fact the share prices of British equities have risen steadily over the last several years, with British index funds replicating the FTSE 100 up over 36% since the Brexit vote versus 46% for the S&P 500, with the broader FTSE 250 Index up over 35%. Investors could’ve gotten that same exposure here in the U.S. by buying HEWU, which is up almost 34% from the Brexit vote through 9.20.19. That’s not too shabby considering the amount of uncertainty overhanging the British market, with investors seeming not to demand too much of a risk premium for holding onto that uncertain future.

Not surprisingly, the biggest detractor from the returns has been currency risk, with the pound being driven back to multi-year lows at the 1.2 level versus the dollar. For those who enjoy the currency risk, the high volatility of the pound relative to the U.S. dollar has resulted in periods where the return to unhedged British equity funds has been more in line with domestic equities – like in 2017, when an appreciating pound offered more lift for U.K.-oriented funds.

And as you can see from our earlier chart, the pound has found support again at the 1.2 level versus the dollar, and has even begun to bounce higher on optimistic comments from the EU about finding a negotiated settlement to the current situation. Or perhaps the fact that Boris Johnson’s obvious attempts to crash out in a hard Brexit have been rejected multiple times by multiple bodies. But focusing just on the macro situation ignores an even more obvious trend: FKU is better optimized to capture the resurgent trend of stronger performance among smaller stocks.

Small versus Big

FKU and EWU might both invest in British equities, but only in the same way that a large-cap and mid-cap index ETF are both invested in American stocks.

Both funds have a large number of holdings – 75 for FKU and over 100 for EWU – but they have relatively little overlap, with FKU missing over 50 of larger EWU’s holdings, including some of Britain’s largest companies. Mega- and large-cap names like HSBC, BP and AstraZeneca (AZN) that make up a large percentage of EWU are totally absent from the smaller FKU. In terms of percentage weighting, those missing holdings are over 50% of EWU’s total portfolio, which means FKU is about as different a fund as you can imagine, while still representing the same country.

Instead, FKU has a slightly more concentrated portfolio of smaller names, although the fund still plots in the mid-cap core box versus EWU, which has more of a large blend-to-value feel. FKU also employs a different weighting methodology that reduces the portion of the portfolio in large-cap names and more evenly distributes the fund’s sector weightings. From a sector perspective, that means while EWU is heavily allocated in energy, financial and consumer staples stocks, FKU has more than half of its portfolio invested in industrial and consumer discretionary stocks.

That should matter to investors, as it gives FKU a more cyclical feel, where EWU has a more, “old guard” nature about it. It relies on strong performance from late-cycle or even defensive sectors to deliver solid returns, making it a less than solid choice for investors looking for long-term exposure to British equities, especially with the currency fluctuations added to the equation.

Conclusion

There’s no doubt that the coverage of British politics will remain bleak for the foreseeable future, but with smaller, more cyclical funds like FKU showing a promising set-up, it might be time for investors to put that cloudy island back on their watchlist.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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