Reducing financial sector exposure in your ETFs

Colombian Bank ShortingEnlarge Graph

Several Latin America oriented ETFs such as MSCI Brazil Index Fund (EWZ) or Global X InterBolsa FTSE Colombia 20 ETF (GXG) have a larger proportion of their holdings concentrated in the financial sector. These holdings are usually concentrated in nature, with a few large cap securities accounting for most of the sector exposure. While the increased concentration may be seen as a negative by most investors, the keen investor may be able modify his or her exposure to the sector accordingly.

An example of an ETF with too much financial exposure is GXG. A quick glance at its fact sheet will reveal that the ETF’s financial sector exposure is almost 25%. First of all, investors need to avoid being mislead by the category titles. For example, GXG’s exposure to the Financials sector seems to be only 17%, but there is an additional 7.5% within a  category called Financial Services. Reviewing the Top 10 Holdings in the fact sheet will show that Bancolombia, Grupo Aval and Banco Davivienda are the main financial stocks in the portfolio, and that they account for c. 22% of holdings. Investors not familiar with the emerging market companies highlighted in fact sheets can perform a quick Google Finance search to define the industry classifications for unknown tickers.

Below we illustrate how to neutralize the exposure to the financial sector by selectively shorting the ETF holdings. The process is as follows:

  1. Find the ETF portfolio holdings for which exposure is to be eliminated.
  2. Calculate the weight of those companies within the ETF and get the equivalent dollar value for the investment in the ETF.
  3. Divide the dollar share of each company by its price to get the number of shares to short.

For example, Bancolombia is currently trading at COP27,600, equivalent to $15.19.  Bancolombia has a weight of 12.1% in GXG, so assuming a $1,000 investment in GXG, the dollar share of Bancolombia would be $121.In order to eliminate the exposure to Bancolombia, one would have to  sell short the equivalent amount of shares, which is obtained by dividing the dollar exposure by the share price: $121.00 / $15.19 = 8 shares. The 8 shares sold short would cancel out the $121 of exposure to Bancolombia. The same could be done for the other three banks, as shown below. Note that the number of shares may not be a whole number, in which case one can round to the closest whole number, keeping in mind the hedge will not be perfect.

Shorting the financial exposure in GXG assuming a $1,000 investment

Enlarge Graph

This same technique can be used for other markets; for example, shorting Itau and Brasdeco from EWZ would eliminate approximately 2/3 of the direct exposure to Brazil’s financial sector.

Given the current market conditions, Colombia is one of the more attractive markets in Latin America, making GXG an attractive investment. Many analysts, though, are worried that retail banking may have expanded too quickly and that growth may slow down to allow banks to strengthen their balance sheets.  Hedging out the financial sector exposure in this ETF may allow investors to participate in the promising overall Colombian market upside without exposing the portfolio to the uncertainty of the financial sector.