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With the Spanish economy seemingly sinking back into the abyss, many investors have stayed focused on the nation as a barometer for broad euro zone troubles. However, issues are also starting to build in an even bigger country in the euro zone, which could make Spain’s problems look small in comparison.

That nation is Italy, one of the ten largest economies on earth with a total GDP of about $1.8 trillion, a level that is roughly $400 billion greater than Spain. In other words, the difference between the Spanish and Italian economies’ size is about $100 billion more than the entire Greek economy (read Pain In The Spain ETF Continues).

Thanks to this, the Italian economy is a behemoth among PIIGS nations and is likely to eventually set the pace in terms of worries over the bloc. This suggests that while the focus may be on Spain right now, it will eventually shift to Italy, especially if current troubles in the country continue (see more in the Zacks ETF Center).

This is because Italy appears to be falling back into a low growth, high unemployment quagmire, much like its counterparts in the space. In fact, unemployment is the country is now at a 12-year high—nearly 10%-- while the nation is currently fighting through its fourth recession since 2001, according to Bloomberg.

Given these figures, as well as some gloomy predictions from government officials regarding the pace of recovery and job growth, and it appears as though Italy could be stuck for quite some time. Unfortunately, this disappointment is beginning to be reflected in the country’s stock market, as evidenced by the weak performance from the main equity way to play the country in basket form; the iShares MSCI Italy Index Fund (EWI - ETF report).

The popular ETF tracks the MSCI Italy Index and surged to start 2012, adding over 10% in the first month of the year. However, as troubles have begun to build in recent weeks, the product has slumped back to earth and is now flat on the year, including a nearly 8% loss in the past month alone (read Three Unlucky Equity ETFs).

As a result, EWI is now dangerously close to its 52 week lows, representing a huge slump from the fund’s position just a year ago. In fact, the ETF has lost close to 40% of its value in the past year, a nearly 1,000 basis point underperformance when compared to the broad-based iShares MSCI EMU Index Fund (EZU - ETF report) over the same time period.

Sector Troubles As Well?

Beyond the impressive structural problems facing the Italian economy, the Italy ETF isn’t exactly helped by its sector breakdown either. The ETF only holds 30 components in total and a whopping 72% of assets go to the top ten holdings alone, suggesting high levels of company specific risk.

This issue is further compounded by the single security allocations that are in the top few holdings of the ETF as the three biggest firms account for more than 47% of assets. In fact, ENI SpA (E - Analyst Report) makes up over 23% of the total assets, giving the fund a heavy allocation to the energy industry as well.

Overall, 33% of the fund goes towards the energy sector, 26% to financials, and 19% to utilities. Given the focus on the low growth segment of utilities, the heavy exposure to E in the energy space, and the nearly one-quarter assets in the deeply troubled financial sector, and it shouldn’t be too hard to see why the fund is having trouble from this view either (see 11 Great Dividend ETFs).

This heavy concentration also means that a number of segments are smaller than you might expect or completely absent from the fund all together. Only three other sectors even find their way into the product while companies in the technology, consumer staples, basic materials, and health care industries receive no allocation whatsoever in the Italian ETF.

Clearly with this heavy concentration in just a small number of companies in a few sectors, EWI can be very susceptible to adverse events in a few corners of the market. While the energy sector has held up rather nicely, the huge banking sector has not, dragging down the rest of EWI in the process.

The two biggest financial stocks in EWI—Intesa Sanpaolo SpA and UniCredit SpA—are down, respectively, 14% and 52% so far this year, creating a poor backdrop for this European ETF in 2012, especially considering that these two financials account for nearly 13% of total assets in the product.

In other words, EWI is probably an ETF that you want to stay away from for the foreseeable future. Yes, the product is beaten down and may be a decent value for longer term investors, but the trend to downside seems like it will be hard to shake.

The Italian economy is extremely weak and with the continued budget cuts and broad euro zone slowdown, this trend could easily extend into the summer. Furthermore, the fund breakdown isn’t exactly favorable and the product is heavily concentrated in a few securities, far beyond what investors see in similar country specific ETFs in the region (also read For Europe ETFs, It Is Hard To Beat Switzerland).

This suggests that the product isn’t even that good from a diversification perspective and that those seeking to make a long bet on the euro zone would be better served by looking elsewhere. As a result of both the weak Italian economy and the poor structure of the product, we see no reason why EWI could not test its 52 week lows at some point in this quarter.

The European mess doesn’t look likely to be solved at any point in the near future, and eventually the focus will shift to Italy and EWI, implying another rough patch is ahead for investors in this concentrated product.

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