A Smarter Play on Italy

 | Jan 11, 2012 | 12:30 PM EST  | Comments
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Stock quotes in this article:

EWI

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e

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ITLY

This piece originally appeared on ETF Profits.

First, it was Ireland. Then there was Greece. Now the crosshairs of the European fiscal debt crisis have moved on to Italy, the member of the "PIIGS" bloc -- or Portugal, Italy, Ireland, Greece and Spain -- that could make or break the common currency.

 After the initial excitement of a change in Italy's political leadership last year, concerns over the long run outlook for the economy have gradually intensified. Italy has made no progress toward aggressive deficit reduction targets, and unemployment remains unacceptably high. Plans to fund the government through borrowings of about 440 billion euros this year seem hopelessly naive, especially with borrowing costs continuing to climb.

There is no way around it: Italy is in the midst of a full-blown fiscal crisis -- one whose impact will be felt far beyond the country's borders.

There is an old saying that crisis begets opportunity, and that certainly applies to Italy in the current environment. Italian stocks have been hammered in recent months, putting them on the radar screens of investors seeking out bargain buys. The iShares MSCI Index Fund (EWI) has lost nearly 25% of its value over the last year, and is down almost 60% over the previous five years.

For those who believe the cash-strapped economy will ultimately recover, EWI could be jumping out as an attractive option. But there are a few aspects of EWI that are worth a closer look before jumping in, whether you're looking to bet on a recovery with a long position or gamble on further deterioration of Italian stock prices with a short sale.

EWI, like many international-equity ETFs, is heavily dependent on the financial and energy sectors. Oil stocks make up nearly one-third of the total portfolio, while banks represent one-quarter. But the concentrations in EWI aren't simply limited to sectors. Eni (E), the large, multinational energy company, accounts for about 22% of this ETF's holdings.

The oil giant is anything but a pure play on the Italian market, with Eni operations based primarily in Libya, Egypt, and Nigeria. That means that geopolitical tensions in the Middle East -- not changes in Italian consumer confidence or the government's efforts to scale back spending -- could be the primary drivers of returns to a stock that makes up nearly 25% of EWI's holdings.

There's another potentially complicating factor in all of this. Many components of EWI, including Eni, count the Italian government among their largest and/or most influential shareholders. State ownership is rather common in Italy, especially among the mega-cap stocks that are found at the top of EWI. Considering that Italy's cash crunch is intensifying and recent efforts to curb the widening of the budget deficit have been unsuccessful, that feature could throw a wrench into any play on this ETF.

EWI is hardly a pure play on Italian stock markets, and overall there's simply too much noise in EWI to make it a viable option for investors looking for exposure. That makes the movements of this fund are difficult to predict, even if you know exactly where Italy is headed.

For these reasons, this fund probably isn't the most effective way to achieve exposure to the Italian economy right now. The better option could be Italian bonds, as represented by the DB Italian Treasury Bond Futures ETN (ITLY). Yields on Italian government debt have skyrocketed as the crisis has intensified, with 10-year Italian bonds now yielding more than 7.1%. More important, that yield comes in at about 525 basis points higher than German bonds, which are viewed as one of the few relatively safe havens in the eurozone.

If Italy does indeed get back on the right track, ITLY should deliver solid results. Even if the country manages to tread water for a while, the hefty current return component might be attractive to yield-focused investors. If, on the other hand, Italy goes straight down the tubes, ITLY stands to lose a significant amount of its value in coming weeks. But, whether you're a bull or a bear, this ETF might be the more effective tool for tapping into any opportunities seen in this country.

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