South Africa ETF Vulnerable Amid Political Volatility (EZA)

Political volatility is always a potential pitfall of investing in emerging markets. Currently, South Africa is reminding investors of that fact. The iShares MSCI South Africa ETF (EZA), the largest South Africa-focused exchange-traded fund (ETF), is up 8.9 percent year to date, which sounds impressive until acknowledging that the MSCI Emerging Markets Index is higher by 13.3 percent. South Africa is the sixth largest country weight in the index, which is a widely followed emerging markets benchmark.

Investors have reasons to be concerned about the possibility of EZA and South African stocks not only continuing to lag the MSCI Emerging Markets Index but faltering as well. Late Thursday, South African President Jacob Zuma removed Finance Minister Pravin Gordhan, a news event that roiled financial markets. EZA fell 1.8 percent yesterday on volume that was slightly above the daily average, underscoring the point that investors were not pleased with news of Gordhan's removal.  (See also: EZA: iShares MSCI South Africa ETF.)

"The South African Communist Party, an ally of the governing African National Congress, had earlier lodged a formal objection to plans to dismiss Mr. Gordhan, who is widely respected internationally," reports the BBC.

South Africa's equity markets and EZA have been largely bolstered this year by rising precious metals prices. The country is a major gold producer along with being the largest platinum producer and second largest palladium-producing nation. Additionally, of the platinum group metals (PGM) mined by South Africa, 10 percent is rhodium, one of this year's best-performing commodities. Interestingly, EZA is not overtly reflective of South Africa's status as a major metals producer. The materials sector is 6.2 percent of the ETF's weight. Financial services and consumer discretionary​ stocks combine for about two-thirds of EZA's roster. (See also: A Primer on Palladium.)

The news of Gordhan's departure is ill-timed for another reason. South Africa, Africa's second largest economy behind Nigeria, has a tenuous grasp on an investment-grade credit rating, having narrowly dodged a downgrade to junk status by Standard & Poor's late last year. S&P and Fitch Ratings currently have BBB- ratings on South African sovereign bonds, the lowest investment-grade rating. (See also: Fitch Downgrades South Africa's Outlook.)

South African stocks are usually more volatile than broader emerging markets indexes. EZA has a three-year standard deviation of 22.2 percent, which is 600 basis points above the MSCI Emerging Markets Index.