How to play Europe with minimal risk

As Goldman Sachs put it in a recent report, "economic differentiation is a key theme across Europe for 2010". In other words, you need to pick and choose where you invest, rather than whacking all your money into a generic European fund. The good news for investors who favour funds over individual stocks, is that you can now buy exchange-traded funds (ETFs) to track pretty much any European index you care to mention.

So which countries look most promising? If you're an income investor, then Spain's Ibex index at first looks to be the most obviously attractive play. The dividend yield on the Spanish index is around 4.7%, compared to the FTSE 100's 3.2%, for example. And it can be tracked with the Lyxor Ibex 35 ETF.

However, as you might imagine, there's a catch. More than half of the index's capitalisation is accounted for by two banks (Banco Santander and BBVA) and a telecoms firm (Telefonica). On top of that, there are more banks in the Ibex than in any other European index. Given Spain's precarious financial position as one of the PIIGS, we'd give this one a miss.

A better bet could be the Swiss index, the SMI. Like the Ibex, the SMI used to have a bank problem. However, following the credit crunch and the capitulation in Credit Suisse, Julius Baer and UBS share prices, the SMI is a very different animal today. It holds the fewest stocks of a major index, so it's not as well diversified as some. However, as most of these positions are in 'defensive' or stable cash-flow industries, it has a high negative correlation to the economic cycle.

You can think of it more as a trim investment fund than a national index. The economic backdrop adds to the argument. Switzerland's financial infrastructure is internationally respected as a safe haven. The Swiss franc is strong, the bond market is secure and the stockmarket has decent returns (an average gain of 4.4% inflation-adjusted a year). The key holding, Nestl (see Four of Europe's most solid stocks for more), is the world's biggest food company, and the template of a defensive stock. It accounts for 25% of the SMI index's value. You can buy the Swiss index via the SMI ETF (SW: XSMI), which has an annual total expense ratio of 0.3%. And you don't have direct exposure to the euro either.

If you're looking for the strongest economy in Europe, then Norway could be a good home for your money. Last year Norway had a current account surplus of $87.9bn, compared to Britain's deficit of $43.3bn. It's the world's fourth-largest oil exporter. And the population enjoys the second-largest level of GDP per head in the world. With 51% of stocks in the OBX market exposed to the domestic economy, it is among the most nationally representative indices in Europe. So, should the nation's stocks follow the economy's upward march, this would be a good place for your investment capital. You can invest in the OBX index using the Norway-listed DnB NOR OBX ETF (NO: OBXEDNDN).

But you have to tread carefully. Norway is an example of what Goldman Sachs calls a 'micro' index it is highly concentrated, and highly correlated to the oil price. Oil and gas stocks make up over half of the index, so a bet on Norway is a bet on oil's strength continuing and, as we note (see: Oil price on the rise again), that's by no means a sure thing.

But what if everything falls?

These are all interesting plays on European stockmarkets. But given the strength of the past year's rally, is now the best time to be buying any stockmarket? Markets across the world face plenty of headwinds. The admittedly bearish David Rosenberg of Gluskin Sheff says: "Our equity models point to r oughly a 15% overvaluation right now." He's not the only one. Bank Sarasin also believes the economic cycle has peaked. "Following the strong first quarter there will soon be fewer positive surprises. The risk of a significant setback in equity markets will therefore increase significantly," says Philipp Baertschi of Sarasin.

No single index no matter how defensive can completely insulate your wealth from a downturn. But if you're comfortable with spread betting, then you could consider pairs trading. You can find out more about pairs trading in the supplement enclosed with this issue, but here's a brief summary.

First, find a pair of stocks or indices. Then buy the one you consider to be undervalued, and sell the overvalued one. Finally, unwind the trade when they 'revert to the mean' ie, when neither is over or undervalued.

A promising option would be to buy the SMI and short the FTSE 100. The FTSE 100 is made up of 42.9% energy stocks, mining stocks and bank stocks, which are all cyclical. By contrast, as noted earlier, the Swiss index of 20 leading stocks is steeped in mainly defensive firms. And the benefit of this pairs trade is that it's even more defensive than buying the SMI outright. If the market is falling, and both of your positions are going down, it's likely that the more expensive stock, the one that is more overbought, will fall further.

In other words, if the SMI falls 5% and the FTSE 100 falls 10%, you make net 5% on your investment. An investor who only holds SMI and no short position in the FTSE will only see the downside in their position. And the trade worked well during the brief market correction earlier this year. The SMI was the only European index that was profitable in January, when the FTSE was down. At that time, this pairs trade idea would have made 3.4%. That's about 333 points on a spread bet (FTSE down 180 points, SMI up 153 from 2 January 24 February). Do bear in mind that when spread betting, if the trade goes against you (i.e. the FTSE 100 outperforms the SMI), then you can lose a lot more than your initial stake. Find the right spread-betting provider for you here.

This article was originally published in MoneyWeek magazine issue number 482 on 16 April 2010, and was available exclusively to magazine subscribers. To read more articles like this, ensure you don't miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now and get your first three issues free.