A Look at U.K. ETFs Ahead of the Scotland Referendum

Scotland’s independence referendum, scheduled for Thursday Sept. 18, has, not surprisingly been a thorn in the side of some U.K. exchange traded funds.

Funds focusing on U.K. equities listed outside the U.S. have recently been hit by outflows. “Funds that invest purely in U.K. equities experienced 27 days of outflows from July 1 to Sept. 8, equivalent to $1.97 billion, versus 23 days of inflows,” reports Sarah Jones for Bloomberg, citing EPFR Global data.

“Since last weekend’s poll showed that the nationalists had overtaken the pro-union campaign in garnering a slender, single-point majority for the first time, UK financial markets have sold off sharply with sterling and gilts shouldering the brunt of the losses and Scottish banks absorbing much of the decline in the FTSE 100,” said S&P Capital IQ in a new research note.

Already showing signs of vulnerability before the Scottish independence vote gained steam, the CurrencyShares British Pound Sterling Trust (NYSEArca: FXB) has been hammered after being one fof the best-performing developed market currency ETFs in the early stages of 2014. FXB is down 4.4% over the past 90 days, a slide exacerbated by a 4.4% gain for the PowerShares DB US Dollar Index Bullish Fund (NYSEArca: UUP) over the same period. [Scotland Independence a Problem for U.K. ETFs]

“Indications in the latest two surveys of a reversal in intentions among Scottish voters in favor of independence caught foreign and domestic investors by surprise, subjecting sterling and UK government debt to vigorous selling pressure. Although UK stocks may suffer some further losses before and after the outcome of the plebiscite, propitious fundamentals in the aggregate and at the corporate level should help partly shelter them from any deleterious implications. Nevertheless, as a precaution against any additional erosion of value, Global Markets Intelligence (GMI) recommends investors trim exposures to a modest one-point overweigh,” added S&P Capital IQ.

The research firm rates the iShares MSCI United Kingdom ETF’s (NYSEArca: EWU), the largest U.K. ETF, marketweight. EWU is down 1% in the past month and in a sign of the rising volatility U.K. stocks are enduring in the run-up to the Scottish referendum, EWU rose 0.2% Monday on volume that was nearly five times the daily average.

Not only has EWU had to contend with the specter of Scottish independence, but the issue of massive legal liabilities facing one of the ETF’s largest holdings. U.S. District Judge Carl Barbier that BP (NYSE: BP) faces as much as $18 billion in civil penalties for its role in 2010 Gulf of Mexico oil spill. BP is EWU’s third-largest holding at a weight of almost 5%. [BP Weighs on Energy ETFs]

On the bright side for British equities and U.K. ETFs is a valuation argument, that being the market currently trades at a discount to its historical average.

“The FTSE’s positive-adjusted, one-year forward price-earnings multiple (p/e) of 14.0x seems relatively cheap since it is 1.8 points below its historical average (15.8x) and 15.4 points lower than its record high (29.4x), regardless of the fact it exceeds its all-time low by 6.6 points. Also, British shares are trading at a firm discount to many Western European markets, except the German DAX and Norwegian OBX. Furthermore, relative to their continental bellwethers, UK equities appear quite inexpensive, which is apparent in their trading at a 0.26point discount to the S&P Europe 350 index,” according to S&P Capital IQ.