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UK ETFs in Focus on Positive Outlook

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Europe has finally broken free from a prolonged recession. And one of the region’s weakest members, the UK, is now leading the way in a broader European recovery. The nation revisited the growth path in the first quarter of this year going against analysts’ forecast of a triple-dip recession.
Economic growth in the U.K. continues with 0.7% recorded in the second quarter and 0.8% in the third, reflecting the fastest pace in more than three years. Despite tough comparisons owing to last year’s Olympics and Paralympics, Q3’s GDP was also 1.5% higher on a year-on-year basis.
The expansion was broad based with agriculture, services, manufacturing and construction all posting sizable growth. Output growth from the service sector has now inched past its prior peak in the first quarter of 2008. Also, the UK’s largest trading partner – Eurozone – has started to expand thus providing a much-needed boost to the business confidence of the former (read: Play a Resurgent Europe with These ETFs).
In fact, the third-quarter growth was no less robust than that of the U.S. economy which grew 2.8% on an annualized basis including as much as 0.8% weight toward inventory pile-up. Investors should note that, the U.K. growth is presented on a quarterly basis; it’s not an annual run.
As per the official figures, the U.K. economy registered an annualized GDP growth rate of 3.2% in the third quarter, 40 basis points above the Q2 figure. Quite expectedly, this bullish data gave investors a reason to lean on developed markets once again.
Upbeat Economic Indicators Roundup
Falling Unemployment Rate: With the economy gathering strength, the jobless rate in the U.K. (7.6%) fell to the lowest level in over four years in Q3. The rate bettered the Bank of England (BOE)’s prior expectation.
The BOE moved forward the achievement of its threshold jobless rate target (7.0% or lower) to 3Q 2015 from its earlier timeline of 2016 end. The Monetary Policy Committee sees only a two-in-five probability of reaching this goal by 2014's end.
Smooth Inflation Track: The CPI (consumer price index) numbers in the economy have been oscillating in the range of 1.0% plus to 2.0% plus since September 2004 barring some occasional spikes. This probably explains the persistent cut in the key policy rate by the Central Bank.
The CPI numbers fell sharply to 2.2% in October 2013 from 2.7% in September which Prime Minister David Cameron deemed as “encouraging news for hard-working people”. Inflation took a major step toward the target limit of 2.0% thanks to the monetary authority.
Easing Pressure on Interest Rate Policy: The economy has been witnessing significant rate cuts since July 2007 when the benchmark rate then was 5.75%. Since then, the interest rates have been reduced by 5.25% in total.

The monetary authority plans to leave interest rate unchanged at the ultra-low level of 0.5% unless unemployment rate falls to 7% or lower.  However, while better jobs data and improved GDP sparked up the possibility of an interest rate hike among investors, the fall in inflation offsets the likelihood of this (read: Euro ETFs in Focus After Surprise ECB Rate Cut).
Some Respite for Currency: The British Pound Sterling has been awaiting a turnaround for the past few months and finally seems to have got a boost from stronger economic recovery in the U.K. that spurred speculations about the central bank’s less accommodative monetary policy ahead of the anticipated timing.
To add to this, the Fed’s prospective head Janet Yellen’s dovish comment about the continuation of the QE program provided a relief to the struggling currency pushing it up more than 6.0% relative to greenback in the last four-month period (as of November 15, 2013).
Raised Growth Outlook: To reflect better-than-anticipated data economic data, the central bank lifted its GDP growth forecast for 2013 to 1.6% from 1.4% projected in August. The economy is now looking to expand 2.8% in 2014.
How to Play?
While much work is still left to fully regain the ground lost in the crisis, the U.K. remains an interesting choice for investors looking to play on European recovery but without euro exposure. For those seeking to tap this developed economy in ETF form, there are three options available at this time, each of which we have highlighted below (read: 3 European ETFs Leading the Recovery):

iShares MSCI United Kingdom ETF (EWU - Free Report)

Launched in March 1996, EWU is the largest and the most popular British ETF having AUM of about $3.36 billion and trading at an average daily volume of 1,100,000 shares.

It tracks the MSCI United Kingdom Index. The capitalization weighted index holds some of the biggest names in the U.K. equity markets such as HSBC Holdings plc, Vodafone Group plc, and BP plc.

The ETF has now grown 16.43% in the last one year ending September 30, 2013. EWU holds109 securities presently and allocates around 42.5% of its total assets in the top 10 holdings thus carrying a certain concentration risk.

The ETF charges 49 basis points in fees and expenses to investors. The fund currently carries a Zacks ETF Rank #1 (Strong Buy).

First Trust United Kingdom AlphaDEX (FKU - Free Report)

Launched in February 2012, FKU is a relatively newer product in the British ETF list. It tracks the Defined United Kingdom Index and employs the AlphaDEX methodology of stock selection.

According to this methodology, stocks are chosen from the S&P United Kingdom BMI universe and ranked on the basis of various fundamental growth and value factors.

The higher ranked stocks receive a bigger weighting while the lowest rated securities are excluded entirely. The ETF seeks to outperform the underlying index, thereby generating positive ‘alpha’.

On the flip side, investors are charged a hefty premium of 80 basis points in fees on account of its enhanced methodology. So far, the ETF has managed to generate total assets worth $21.8 million and has an average daily volume of about 4,500 shares. The fund currently has a Zacks ETF Rank #2 (Buy).

iShares MSCI United Kingdom Small Cap (EWUS - Free Report)

EWUS is yet another product tapping the U.K. markets but in the small cap space. EWUS debuted in January 2012 and looks to follow the performance of the MSCI United Kingdom Small Cap Index (see Europe ETF Investing 101).

The index measures equity performance of small cap companies whose market capitalization represents the bottom 14% of the U.K equity markets.

Holding 238 securities in the portfolio, the fund has amassed about $19.2 million in assets. EWUS allocates its assets in almost an equal weight ensuring that concentration risk is nearly diversified. Just 13% exposure in the top 10 holdings also confirms this fact.

Unfortunately, the expense ratio for the fund stays high at 59 basis points. The product added a massive 33% return in the last one year ending September 30, 2013.

Given its small cap bias, the ETF is expected to outperform the broader market in case of an economic recovery, as small caps tend to top their large and mid cap counterparts at times of recovery. The fund currently has a Zacks ETF Rank #3 (Hold).

Bottom Line

While signs of economic revitalization are on the horizon, there are also bumps ahead for the British economy. Gains, mainly from housing, have helped drive growth so far this year, but unemployment still remains high.

As per the Central Bank, though ticked-up, activity levels still fall short of the historic averages. Also, the BOE feels inflation will likely inch up in the upcoming months once the new utility prices are effective and that quarterly GDP growth rates may soften next year.
Despite this cautious comment, the nation is better placed than most other European countries and the aforementioned funds could move higher in the coming months as depicted by their favorable ranks, and the solid trends at their backs.

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