Iceland Volcano Will Hurt Airline ETF

Claymore/NYSE Arca Airline ETF (FAA) will experience some turbulence based on the large volume of flight cancellations to and from European destinations.
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NEW YORK (TheStreet) - Claymore/NYSE Arca Airline ETF (FAA) will experience some turbulence based on the large volume of flight cancellations to and from European destinations.

The

volcanic eruption

is estimated to be costing airlines $200 million a day, although at this point, many airports in southern and eastern European countries are reopening. This leaves airports in northern Europe, such as the United Kingdom and Ireland, still waiting for the ash-cloud to clear. Experts do not yet know for sure when this may be.

The volcanic substance in the air is dangerous for aircraft because it has a glass-like composition, and will liquefy upon entering a hot engine, potentially causing it to stop. The longer the problem persists, the longer FAA will suffer.

Although, the companies that receive the largest allocations in FAA are American, the fund does have a 10.4% allocation to airlines based in Europe. The three largest holdings are

Continental Airlines

(CAL) - Get Report

,

Delta Air Lines

(DAL) - Get Report

, and

Southwest Airlines

(LUV) - Get Report

, which account for 15.5%, 14.7%, and 14.5% of the fund, respectively.

Although they will suffer less as a total percentage of their business, non-European companies will be hurt by the ash-cloud, since international flights to and from locations all over the world with European destinations or origins have been cancelled.

Aside from the pure play airline ETF, the volcanic eruption may also affect broad transportation sector instruments like the

iShares Dow Jones U.S. Transportation Index Fund

(IYT) - Get Report

and the

Fidelity Select Transportation Portfolio

(FSRFX) - Get Report

.

Like FAA, these funds also boast considerable exposure to top airline companies. IYT has 8% of its index dedicated to the industry while FSRFX has three to four times that amount and some of the world's largest airlines among its top ten components.

Additionally, some of the companies in these funds with operations in Europe, such as

FedEx

(FDX) - Get Report

and

United Parcel Services

(UPS) - Get Report

, also rely on air travel for some of their services.

As I wrote about on

Friday,

IYT looks as though it is a strong play on the continuation of America's economic recovery. I still believe this is the case, but investors should not be surprised if the unexpected disruption in air traffic over Europe causes some temporary turbulence for the ETF.

If the ash-cloud problem over Europe persists, the transportation companies in IYT can figure out alternative means to deliver product, such as by land or sea. However, this is not necessarily true for the airline companies in FAA since transporting passengers by air is the sole platform of their businesses.

Investors with exposure to commodities should also watch out for a drop in oil prices caused by the cloud of volcanic ash and the ensuing flight cancellations. A large number of cancellations will affect the demand for oil, since airline companies will have larger inventories of unused fuel after grounding fleets of planes.

For now, the bottom line is that the economic impact of the ash-cloud over Europe depends on how long it lingers in the continent's air space, which as of yet, cannot be predicted. The impact to airlines could be lessened if the air clears quickly, although there is the possibility that the initial eruption could trigger a larger secondary eruption. Another scenario is that more similar eruptions could periodically occur over many months.

Investors holding FAA should realize that the market will be pricing in the new losses for airline companies today, which are now above $1 billion, but a slide in the ETF could continue into the future depending on how air currents disperse of the ash-cloud and on whether or not further eruptions occur.

Investors can choose to initiate or add exposure to FAA if they want to bet on a speedy resolution to this problem or just steer clear of the fund for the time being until the meteorological uncertainties for the airline industry are resolved.

Don Dion is president and founder of

Dion Money Management

, a fee-based investment advisory firm to affluent individuals, families and nonprofit organizations, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages assets for clients in 49 states and 11 countries. Dion is a licensed attorney in Massachusetts and Maine and has more than 25 years' experience working in the financial markets, having founded and run two publicly traded companies before establishing Dion Money Management.

Dion also is publisher of the Fidelity Independent Adviser family of newsletters, which provides to a broad range of investors his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With more than 100,000 subscribers in the U.S. and 29 other countries, Fidelity Independent Adviser publishes six monthly newsletters and three weekly newsletters. Its flagship publication, Fidelity Independent Adviser, has been published monthly for 11 years and reaches 40,000 subscribers.