Big Bets on a Troubled Sector

For the most part, financial stocks haven't gotten a lot of love from investors in recent years. In the wake of the financial crisis, the proverbial curtain was drawn back from these institutions to reveal rotten balance sheets and inflated assets that in reality were worth next to nothing. Financials received a well-deserved drubbing in the stock market, with some bellwether institutions losing a significant portion of their value in short order.

Of course, in the rush to punish "bad" banks and financial institutions, even those companies that exhibited more fiscal responsibility got battered down along with the rest. And my guess is that just as the market drove up the price of financial stocks too high on the way up, it will also overcorrect on the way down. That means opportunity for investors who are willing to pick through the wreckage of this sector.

In fact, after being beaten down to within an inch of their lives in 2007 and 2008 and trailing the broader market by wide margins in 2009 through 2011, financials are finally catching a break. The Financial Select Sector SPDR (NYS: XLF) , one of the largest financial sector ETFs around, is up 8.1% year to date, versus a 4.5% showing for the S&P 500 Index.

Now, I don't think the appetite for risk that we've seen in the opening weeks of 2012 will necessarily last all year. But given how far financials have fallen, there's some significant room for gains in this sector down the line. Here are some ways you can tap into this potential:

Financial overload
One well-publicized all-in bet on financials is being executed by Bruce Berkowitz of Fairholme (FAIRX). After years of peer-crushing performance brought billions of dollars into his fund, Berkowitz was been having a rough go of things lately, thanks to his heavy exposure to financials. According to the most recent Morningstar data, roughly 83% of fund assets are dedicated to financial and real estate stocks.

AIG (NYS: AIG) alone accounts for nearly one-quarter of portfolio assets. Although the stock's performance has been a downer to say the least, AIG has paid back all the bailout money it borrowed during the crisis and currently trades for nearly half of its book value, paving the way for a potential rebound.

Clearly, Fairholme's gamble on financials didn't work in its favor last year, when it lost 32% and ended up at the very bottom of its peer group. But the fund is up 26% so far this year, partly redeeming Berkowitz's heavy-handed approach. It's too soon to tell whether this trend will continue, but shareholders who have stuck it out could finally see some payback this year. With its current heavy sector concentrations, Fairholme is not suitable for more risk-averse investor types, but the fund does represent a reasonable option for investors who want to get in on the ground floor of any future rebound in the financial sector.

A middle-of-the-road approach
If big banks and institutions aren't your thing and you're looking for a more diversified way to get some financial flavor, consider a fund like FAM Value (FAMVX). The management team here takes a cautious approach to investing, looking for firms with healthy balance sheets and strong free cash flows. At last glance, nearly one-third of assets were dedicated to midsized financial names such as insurers White Mountains Insurance Group (NYS: WTM) and Brown & Brown.

Management continues to like White Mountains because it is trading well below its expanding book value while the firm is also buying back stock. Because of the portfolio's conservative nature, this fund tends to shine brightest during market downturns. However, investors who want mid-cap financial exposure within a more diversified framework might want to give this fund a second look.

Turning up the risk
Investors who really want to bump up their exposure to financials can always bypass the more cautious route and buy direct exposure to the sector through inexpensive exchange-traded funds. Besides the financial SPDR referenced above, investors who want global exposure might want to look at iShares S&P Global Financials ETF (NYS: IXG) . If you want specific bank exposure, the SPDR S&P Bank ETF (NYS: KBE) is another option.

While I would recommend that investors take the less risky approach and buy a more diversified fund that leans heavily into financials, if you do want direct financial exposure, make sure you keep your overall allocation low, ideally no more than 5%, to keep risk to a manageable minimum.

The financial sector is not a place for the faint of heart right now, especially given the potential for disaster unfolding overseas in Europe, but investors who are willing to wade in now may end up reaping the rewards if a more lasting rebound does in fact materialize.

No matter how financials fare in the coming months, investors should make sure they aren't completely avoiding this sector since a well-diversified stock portfolio is one of the keys to achieving your long-term retirement goals. If you're not sure if you're on track to retire on time, be sure to check out our newest special free report which highlights the shocking truth about your retirement. Don't miss this chance to grab your free copy of this can't-miss report today!

At the time thisarticle was published Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. Amanda owns shares of Fairholme. The Motley Fool owns shares of White Mountains Insurance Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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