Financial Sector ETFs in Focus

So, if it's true that you should never waste a good crisis, it would appear to be time to place well-considered bets on the shares of financial services companies, since someone is going to have to come out of all this a winner. Trading in bank and brokerage stocks has been particularly heavy in recent years, and exchange-traded funds tracking the financial services sector regularly top the most-actively traded list.

U.S. financial services stocks lagged the broad market rebound in 2009, though they outperformed so far in 2010. While they are fairly expensive now, trading at about 26 times estimated 2010 earnings compared with a P/E ratio of about 13 times for the S&P 5000, financial services stocks' price/earnings-to-projected-five-year EPS growth rate ratio is also three times higher than the broad market's. Standard & Poor's Equity Research has a fundamental neutral outlook for the financial services sector, and recommends investors give it a market weight (16.4% of the S&P 500) in portfolios.

Excluding real estate and leveraged funds, there are just over 30 exchange-traded funds targeting the financial sector, both as a whole and some of its many subsectors, including diversified banking, regional banking, investment banking, insurance, mortgage finance, small caps, and international funds. Collectively they hold about $17.9 billion in assets, according to the Investment Company Institute. For the year to date through June 10, their performance has varied widely, from a 13% gain for the SPDR KBW Bank (KBE) fund to a 14% drop for the SPDR S&P International Financial Sector ETF (IPF).

One ETF, the Financial Select Sector SPDR Fund (XLF), dominates the financial services sector. Its $6.1 billion in assets is eight times more than the next-largest fund in the group and its three-month average daily trading volume of 125 million shares is the second largest of any ETF. Like the sector itself, the fund is heavily weighted to the largest diversified banks, with Bank of America, JP Morgan Chase, and Wells Fargo accounting for almost 30% of its assets.

While S&P Equity Analyst Matthew Albrecht believes these large, diversified banks are "better positioned than smaller peers to perform well throughout the economic cycle," his outlook for this group over the next 12 months is neutral, as concerns over the effects of new regulations keep a lid on any potential rally. These banks are particularly at risk from a proposal to force them out of the derivatives trading business, something that could cut profits at Goldman Sachs by 18%, JPMorgan Chase by 12%, Morgan Stanley by 15%, and Citigroup by 11%, Albrecht estimates.

Of all the finance subsectors, S&P is only positive on the outlook for the regional banking stocks over the next 12 months. "We see credit quality improving at a significant pace, and 2010 earnings benefiting from much lower loan loss provisioning expenses than we previously expected," says S&P equity analyst Erik Oja. Some of the healthiest regional banks may even raise their dividends or buy back shares this year, he says.

There are two ETFs specifically targeting regional and small cap bank shares, each offering a very different type of exposure. The larger of these funds is the SPDR KBW Regional Banking ETF (KRE), with $750 million in assets. With a weighted average market cap of just $1.4 billion, it offers exposure to fairly small banks. As of June 10, 2010, its top holdings were Webster Financial, Fulton Financial, First Midwest Bank Corp; of the 52 names it owns, none is larger than 3.25%.

The $171 million iShares Dow Jones US Regional Banks Index Fund (IAT), on the other hand, is highly concentrated in just two, much larger banks, although it has 67 holdings in total. As of the same day, the fund had 17.4% of its assets in just one company--US Bancorp--and 12% in PNC Financial, unusually high concentrations for any ETF.

For those willing to venture overseas, the iShares MSCI Emerging Markets Financials (EMFN) Sector Index Fund offers exposure to the fast growing Chinese banking market. Concerns that the government will raise interest rates to cool off the economy, thereby slicing bank profits, and a raft of new share sales depressed the shares of China's major banks in the first half of 2010, but S&P's China Investment Policy Committee thinks that "well managed blue-chip issues" are worth buying now. The fund's top three holdings are Brazil's Banco Itau Holdings, South Korea's Shinhan Financial, and Industrial & Commercial Bank of China.

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S&P Senior Financial Writer Vaughan Scully can be reached at Vaughan_scully@standardandpoors.com. Send him your ideas for ETF story topics.

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