Australia's ETF Dilemma: Why EWA's Banking Overexposure Warrants a Reassessment Against Global Peers

The Australian ETF landscape has long been anchored by the EWA (iShares MSCI Australia Financials ETF), a vehicle that aggregates the banking sector's dominance in the local market. However, as global investors increasingly scrutinize structural risks in the banking sector, EWA's heavy concentration in financials—particularly the “Big Four” banks—raises critical questions about its long-term appeal. This article evaluates how shifting credit ratings, low-interest rate environments, and overexposure to a sector facing evolving risks create a compelling case for reallocating capital toward more resilient global alternatives like the EAFE index.

Structural Risks in Australia's Banking Sector: A Looming Overhang

Australia's banking sector, while historically robust, is navigating a complex web of challenges. The Reserve Bank of Australia's (RBA) April 2025 Financial Stability Review (FSR) noted that non-performing loans (NPLs) rose to 1.1% in December 2024, nearing pandemic-era peaks. This trend is driven by rising housing loan arrears, exacerbated by inflationary pressures and prolonged high interest rates. For instance, National Australia Bank (NAB) reported a 20% year-on-year increase in impaired assets, with its business lending book deteriorating faster than peers. Fitch Ratings highlighted that NAB's balance sheet skew toward business lending exposes it to heightened funding competition and margin compression.

Meanwhile, the sector's reliance on offshore wholesale funding—a legacy of central bank programs post-2020—remains a vulnerability. While liquidity coverage ratios (LCRs) and net stable funding ratios (NSFRs) are normalizing, Fitch warns that offshore funding could become costlier during economic stress. This dynamic, coupled with slowing economic growth (projected at 1.5% in 2025 by S&P Global), pressures banks' net interest margins (NIMs) and profitability.

EWA's Concentration Risk: A Double-Edged Sword

EWA's performance is inextricably tied to the health of Australia's banking sector. While the “Big Four” banks—Commonwealth Bank of Australia (CBA), ANZ, NAB, and Westpac—account for ~70% of the ETF's holdings, their collective exposure to structural risks amplifies EWA's volatility. For example, CBA's near-term earnings strength (noted by Fitch) contrasts with NAB's struggles, yet EWA's structure does not allow for such differentiation. This lack of diversification becomes problematic when sector-wide headwinds emerge, as seen in Q1 2025, when NAB's profit decline and elevated impairment charges dragged on the ETF's performance.

Moreover, the Australian Prudential Regulation Authority (APRA)'s phase-out of Additional Tier 1 (AT1) capital instruments by 2027 introduces regulatory uncertainty. Banks must replace these instruments with more reliable capital forms, a transition that could strain balance sheets and reduce returns for equity holders. For EWA, this means potential earnings compression and heightened sensitivity to credit rating downgrades—a risk Fitch and S&P have flagged as plausible if asset quality deteriorates further.

EAFE: A Resilient Alternative in a Diversified World

In contrast, the EAFE index offers exposure to a broader array of sectors and geographies, reducing reliance on any single industry. While global markets face their own challenges—such as geopolitical tensions and inflation—EAFE's diversification mitigates sector-specific shocks. For instance, EAFE's allocation to technology, healthcare, and consumer staples provides countercyclical resilience, whereas EWA's 85% financials weighting leaves it vulnerable to interest rate fluctuations and credit cycles.

The low-interest rate environment further tilts the balance in favor of EAFE. As the RBA anticipates 75 basis points of rate cuts by year-end, Australian banks' NIMs will likely contract, squeezing margins. Conversely, EAFE constituents in regions with more accommodative monetary policies (e.g., Europe) may benefit from stabilizing rates and improving corporate earnings. This divergence is evident in recent performance: EAFE has outperformed EWA by ~8% year-to-date, driven by stronger earnings growth in non-financial sectors.

Investment Implications: Reallocating for Resilience

For investors seeking long-term stability, the case for reducing EWA exposure is clear. The ETF's structural risks—concentration in a sector facing credit quality headwinds, regulatory transitions, and margin pressures—pose significant downside risks. In contrast, EAFE's diversified portfolio offers a buffer against sector-specific downturns while capturing growth in resilient industries.

However, this is not a call to abandon Australian equities entirely. Instead, investors should consider a strategic rebalancing: reducing EWA allocations in favor of EAFE or sector-specific ETFs (e.g., technology or healthcare) that align with global growth trends. Additionally, hedging against interest rate volatility through fixed-income allocations or currency-hedged ETFs could further enhance risk-adjusted returns.

Conclusion: A Call for Prudent Reallocation

Australia's banking sector remains a cornerstone of its economy, but EWA's overexposure to this sector in a high-risk environment demands a reevaluation. As structural risks crystallize and global alternatives offer more balanced growth prospects, investors must prioritize diversification and resilience. The EAFE index, with its broad geographic and sectoral reach, presents a compelling alternative to EWA—a vehicle for navigating the uncertainties of 2025 and beyond.