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.
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
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
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
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
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.
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.
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.
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.
etter capitalization levels and increased awareness for
, 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.
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.
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
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 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.
anguard Financials ETF (
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.
hares Dow Jones U.S. Financial Sector Index Fund (
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
dex S&P 500 Equal Weight Financials ETF (
RYF tries to replicate the performance of the S&P 500
Equal Weight Index Financials. The fund uses replication
Focus Morningstar Financial services Index ETF (
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
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.
To read this article on Zacks.com click here.