Financial Services ETFs - ETF Sector Report

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Overall outlook for the Financial Services Industry in general and major banks in particular (which dominate the industry) continues to be weak though the industry has come a long way since the onset of financial crisis. Some of the key areas of concern for this group are reviewed in detail below.

H i gher regulatory oversight and costs , resulting from their earlier financial misdeeds, are currently a big concern for the banks. Bank regulatory landscape is continuously evolving with new laws for almost everything from capital and liquidity standards to derivatives trading rules and debit card fees. Among the key regulations that we continue to watch are the Dodd-Frank regulations and Basel capital regulations.

The central aim of the Dodd-Frank legislation is to protect against "systemic risk" of the magnitude that we saw in 2008. The legislation proposes to do that by creating a new Financial Stability Oversight  Council,  (FSOC) that  will  be  responsible for  identifying  and  addressing threats to the stability of financial system. Among the issues that FSOC needs to examine in near future are impending bank mergers- Capital One planning to buy the online business of ING and PNC acquiring the US business of Royal Bank of Canada.

The Volker Rule, a part of the Dodd-Frank Act, aims to limit banking entities' ability to engage in proprietary trading and restricts their ability to invest in or sponsor hedge funds or private equity funds. This rule if implemented could potentially change the mix of investment services and products offered by the Wall Street banks, which have been lobbying to relax the ban on proprietary trading.

Basel Capital rules may now require big banks to maintain thicker capital cushions than other institutions. The proposals aim to curb risk-taking and ensure that these banks are able to absorb sudden losses without damaging the broader financial system or requiring taxpayer bailouts. These banks will be required to maintain between 1% and 2.5% of extra capital on top of a base 7% capital requirement for all banks agreed to by international regulators last year and will impact biggest banks like JP Morgan Chase, Bank of America and Citigroup.

  Fragile economic recovery and the risk of double-dip recession also continue to weigh on the sector. Recent economic data and Fed's new "Operation Twist" will further add to the miseries of the sector. While in general, low interest rate environment benefits the banks, as they can borrow at very low interest rates and lend at higher interest rates; the current scenario of prolonged low-rates is different as sluggish loan demand and limited investment opportunities are actually hurting banks' profits. "Operation Twist", which aims to flatten the yield curve, will further hurt the profitability of the banks, which typically benefit from the steeper yield curve.

H ousing and Commercial Real Estate are yet to come out of the woods. Although we are now in the sixth year of housing correction, it still does not look like that the housing prices are going to bottom out anytime soon. Uncertain economic environment and rising unemployment result in low home sales despite very attractive housing prices and low mortgage rates. Some banks also face regulatory investigations and possible fines related to their mortgage underwriting and foreclosure practices. While the losses in the CRE segment have come down in recent past, many regional banks still have high level of non-performing assets in this portfolio and we may see higher losses if the economy slips.

  B alance Sheet growth remains elusive as the loan demand continues to be sluggish and margins continue to be thin. Consumer deleveraging will further hurt the profits. While the credit standards have eased compared to extremely tight conditions a couple years back and the banks are now much more willing to lend, there has not been much loan growth except in the areas of commercial and industrial loans. Further, regulatory uncertainty is also adding to the caution being adopted by the banks regarding lending.

  S overeign debt crisis continues to impact the global financial markets and while most U.S. banks  do  not  have  significant  exposure  to  European  economies,  some  large  ones  have exposure to their European counterparts, which in turn are vulnerable to the events unfolding in that region.

 Partially offsetting the risks are some positives for the Industry as it slowly moves towards recovery.

 I mproving asset quality will result in the provision expenses continuing their downward trend. Many banks have been releasing reserves as a result of decline in the charge-offs, which peaked during 2009.

  B etter capitalization levels and increased awareness for risk management , resulting from the regulatory actions are strong positives, though these have increased costs and uncertainly in the near term.  Many banks, which had borrowed from the Government under the Troubled Assets Relief Program (TARP) have repaid by raising the capital from the private markets. Low loan growth coupled with the restrictions by the regulators on paying dividends or repurchasing shares, has resulted in better balance sheet for most banks. In fact, major U.S. banks have almost doubled their tier-1 capital ratio in the last two years and are now in a much more comfortable capital position compared to the European banks in their preparedness for Basel III norms.

  Liquidity conditions have improved a lot since the dark days at the height of the recession. For most U.S. banks, low cost deposits are the primary source for funding versus commercial papers as the source for banks in some other developed countries. Fed's ultra-low interest rate policy has further improved the liquidity situation.

V aluations look pretty attractive as of now but the factors affecting low valuations are rather long term factors and a turnaround cannot be expected anytime soon.

 Among the various segments within industry, the big money center banks are most exposed to the higher regulatory costs and sovereign debt crisis. Some of the smaller regional banks are currently  in  a  much  better  shape  with  decent  loan  growth  and  cleaner  balance  sheets. Diversified asset managers continue to benefit from the volatility in the markets and continuous shifting of the investors' risk preferences. Publicly traded exchanges also benefit from the increased trading resulting from the market volatility but the bigger issue there to watch out for is the ongoing wave of consolidation. Insurers are a somewhat different asset class. Overall, the outlook for insurers is a little better than that for banks.

  Zacks rank and recommendation

Using quantitative model that uses four factors related to earnings estimates, Zacks Research classifies stocks into five groups, ranging from "Strong Buy" (Zacks Rank #1) to "Strong Sell" (Zacks Rank #5). Zacks rank predicts stock movement over 3 months period. For longer term (over one year), Zacks has built Zacks Recommendation on top of Zacks Rank.

 Zacks Financial Services Industry category, currently includes, 108 companies out of which only three have Zacks Rank #1, ten have Zacks Rank #2, 75 have Zacks Rank #3, eight have Zacks Rank #4 and ten have Zacks Rank #5.

 Looking at the Zacks recommendations for the stocks, 7 enjoy "Outperform" recommendation,

88 have "Perform"  while 11 have "Underperform" recommendation (two are not ranked).

 Taking into consideration all the positives and negatives along with the quantitative model ranks and recommendations, we expect the Financials Industry to slightly underperform the broader market, in the short term as also over medium term i.e. over one year period.

  Looking at the longer horizon (five years+)

In the much longer term, we see more focused operations by the banks. As a result of increased regulatory oversight, the banks are now choosing to focus on their traditional strengths and specialized  businesses.  In addition to  managing  profitability and growth  under  significantly higher capital, risk, liquidity and balance sheet constraints, the U.S. banks, will face competition from some of large banks from the emerging markets, which are expanding in the domestic and international markets. We also see further consolidation in the industry as banks struggle to generate cost efficiencies. And last but not the least, global banking regulators have learnt their lessons from the global financial crisis and are working hard to ensure safety and liquidity of the banking systems worldwide. The banks have been given sufficient time to ensure compliance with the new norms; Basel III norms come into effect in 2019 and stronger, well-capitalized banks with sound risk management systems will emerge as winners in the long term. Thus going into much longer horizon, we expect the industry to outperform the broader market.

Based  on  our  industry  analysis,  we  do  not  recommend  buying  a  Financial  ETF,  if  your investment horizon is three months to one year. However you may consider investing if you have significantly longer term investment horizon and are making the investment as a part of your overall asset allocation strategy to achieve a well-balanced and diversified portfolio. At the same time, we may add that the financials constitute about 16% of the broader market index.

  Financial Equity ETFs

There are 36 ETFs currently placed in the Financial Equity ETF category. Among these, some track the broader industry while there are others which track a particular segment of the industry and there are some that track International financial companies. Here we have reviewed the ETFs which seek to provide comprehensive exposure to the U.S. Financial Services Industry including money center banks, regional banks, insurance companies, asset managers and exchanges. However we may add that most of the ETFs are heavily exposed to and their performance is driven primarily the major money center banks. The indices that these ETFs track are highly correlated and thus we expect no significant difference in the performance of these indices over the long term.

  Financial Select Sector SPDR Fund ( XLF )

XLF seeks to closely match the returns and characteristics of the Financial Select Sector Index. The Financials Sector Index seeks to provide an effective representation of the financial sector of the S&P 500 Index.

  V anguard Financials ETF ( VFH )

VFH seeks to track the performance of the MSCI US Investable Market Financials 25/50 Index. The fund employs a passively managed, full-replication strategy when possible.

  i S hares Dow Jones U.S. Financial Sector Index Fund ( IYF )

IYF seeks to match the performance of the Dow Jones U.S. Financial Sector Index, which represents the financial and economic sectors of the U.S. equity markets, before fees and expenses.

  R y dex S&P 500 Equal Weight Financials ETF ( RYF )

RYF tries to replicate the performance of the S&P 500 Equal Weight Index Financials. The fund uses replication strategy.

  Focus Morningstar Financial services Index ETF ( FFL )

FFL seeks to match the performance of Morningstar Financial services Index, before fees and expenses. The Index is a subset of Morningstar US Market Index and consists of financial services companies. ETF was launched only in April this year and its performance/risk details are not available for the purpose of comprehensive comparison.

 As can be observed from comparative table on the next page, there is not much difference in the performance of the ETFs, as expected and as we stated earlier. Based solely on this fact sheet type information, an investor should choose an ETF based on its expense ratio. XLF has the  lowest  expense  ratio  but  it  has  underperformed  the  other  three ETFs.  Investors may consider VFH, which has the second lowest expense ratio. All these ETFs have ample liquidity and sufficiently large asset base. IYF, VFH and XLF are market cap weighted and thus have higher exposure to big banks, while RYF is equal weighted and is more suitable for investors aiming  for    higher  exposure  to  mid-cap  and  small-cap  financial  stocks.  However,  equal weighting requires quarterly rebalancing and hence this fund has the highest expense ratio of the four.



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Zacks Investment Research

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

This article appears in: Investing , Stocks

Referenced Stocks: FFL , IYF , RYF , VFH , XLF

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As of 4/17/2014, 04:07 PM