Financials ETF Volatility Dampening

By Will McClatchy,

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Financial stocks have driven equity markets up and down for years, but finally in 2010 their wild swings subsided a bit. Still, US financial services companies benefit and suffer from major countervailing forces that insure a fair degree of volatility for years to come.

The core profit engine for bank holding companies is humming. There is an historically large spread between the nearly free rate at which they borrow money and the 5% or more at which they lend out.

At the moment these profits mostly shore up loan writeoffs and fallen investment assets. The good news is that progress is steady, such as Bank of America which is cleaning up its troubled Countrywide unit. Once balance sheets have been restored the Federal Reserve will likely raise its prime lending rate, and its hand may be tipped sooner if inflation kicks up. This will shrink the spread. Lucrative credit card fees, meanwhile, are under attack from legislation and will not be the same cash cow.

Could loan defaults worsen? Some investors worry about legal setbacks where sloppy paperwork have caused courts to block foreclosures. But the more fundamental economic point is that foreclosures, in aggregate, drag down housing prices and give underwater homeowners more reason to default strategically. Foreclosure is not a quick fix.

US Financial Sector (NYSEArca:IYF), Vanguard Financials ( VFH ), and SPDR Financial (NYSEArca:XLF) are the most popular broad-based, low-cost funds for this sector. Breathtaking drops in 2008 were followed by resounding rebounds in 2009, and then 2010 brought solid gains to a sector that now is now back to more than 15% of total stock market capitalization:

Large holding company banks dominate large cap financials ETFs as never before. Treasury and the Federal Reserve have done all they can to prop up big banks and help them swallow failed ones, despite lip service about allowing them to fail. IYF holdings as of early January 2011 were as follows:

J.P. Morgan Chase 7.6%
Wells Fargo 7.0%
Bank of America 6.2%
Citigroup 6.2%
Berkeshire Hathaway 3.3%
Goldman Sachs 3.2%
US Bancorp 2.2%
American Express 2.0%
Morgan Stanley 1.7%
Bank of New York Mellon 1.6%
Total Top 10 Holdings of IYF 41.4%

Other financial subsectors in IYF have important positions:

Banks 39.3%
Financial Services 24.7%
Non-life Insurance 14.7%
Real Estate Investment Trusts 14.1%
Life Insurance 6.0%
Real Estate Investment & Services 0.8%
Securities Firms 0%
Other 0.1%
Total 100%

Most ETFs are thankfully light on smaller regional banks which are expected to take massive defaults on commercial real estate loans which form the core of their loan portfolios. Likewise, mortgage companies are now dirt cheap and now account for relatively small amounts of holdings or have been removed from the index.

Insurance companies have complicated balance sheets and their real estate portfolios especially will be under pressure for another year or two. If broad asset values continue to firm up, they will emerge as solid dividend payers.

Now that fraud and excess has been wrung from the system, remaining brokers, dealers, exchanges and trust banks are probably the group most insulated from liquidity problems and asset value drops.

With sub-sectors taking on wildly different patterns and attributes, a good case can be made for playing them individually or avoiding certain ones with the following ETFs:

  • iShares Dow Jones Regional Banks ETF (NYSEArca:IAT), fees: 0.48%
  • iShares Dow Jones US Broker Dealers ETF (NYSEArca:IAI), fees: 0.48%
  • iShares Dow Jones US Financial Services ETF (NYSEArca:IYG), fees: 0.48%
  • iShares Dow Jones US Insurance ETF (NYSEArca:IAK), fees: 0.48%
  • iShares FTSE NAREIT Mortgage ETF (NYSEArca:REM), fees: 0.48%
  • SPDR KBW Regional Banking ETF ( KRE ), annual fees: .035%
  • SPDR KBW Insurance ETF (NYSEArca:KIE), fees: .035%
  • SPDR KBW Capital Markets ETF ( KCE ), fees: .035%
  • SPDR KBW Bank ETF ( KBE ), fees: .035%

International financial ETFs include:

  • iShares S&P Global Financials Sector ETF (NYSEArca:IXG), annual fees: 0.48%
  • SPDR S&P International Financial Sector ETF (NYSEArca:IPF), annual fees: 0.50%

Attempting to beat traditional capitalization-weighted ETFs is done with a host of products. Almost all weight holdings based on financial fundamentals of the companies themselves, such as revenue-to-sales, dividend yield, earnings growth, etc. These include:

  • First Trust Financials AlphaDEX ETF (NYSEArca:FXO), annual fees: 0.7%
  • PowerShares Dynamic Banking Portfolio ETF (AMEX:PJB), annual fees: 0.6%
  • PowerShares Dynamic Financials Sector Portfolio ETF ( PFI ), annual fees: 0.6%
  • PowerShares Dynamic Insurance Portfolio ETF (AMEX:PIC), annual fees: 0.6%
  • PowerShares Financial Preferred Portfolio ETF (PGF), annual fees: 0.6%
  • RevenueShares Financials Sector ETF (NYSEArca:RWW), annual fees: 0.49%
  • WisdomTree International Financial Sector ETF (NYSEArca:DRF), annual fees: 0.58%
  • Rydex ExpressShares S&P Equal Weight Financial ETF (RYF), annual fees: 0.5%

Finally, several ETFs offer leverage for the short-term trader. Typically they hold short-term futures to track daily returns either up or down and are efficient for quick directional bets, not long-term plays. These include:

  • Direxion Financial Bear 3x Shares ETF (NYSEArca:FAZ), annual fees: 0.94%
  • Direxion Financial Bull 3x Shares ETF (NYSEArca:FAS), annual fees: 0.94%
  • ProShares Ultra Financials ETF (UYG), annual fees: 0.95%
  • ProShares UltraShort Financials ETF (SKF), annual fees: 0.95%
  • Rydex 2x S&P Select Sector Financial ETF (AMEX:RFL), annual fees: 0.7%
  • Rydex Inverse 2x S&P Select Sector Financial ETF (AMEX:RFN), annual fees: 0.7%

Co-founder of, author of two books on investing, and founder of, Will has been writing on indexing issues for 8 years. He holds an MBA from the University of Texas at Austin.

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

This article appears in: Investing ETFs
Referenced Stocks: KBE , KCE , KRE , PFI , VFH

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