Can the Surge in Financial ETFs Continue?


Clearly, 2012 belonged to the financials. The sector emerged as the biggest contributor to the equity market rally, registering hefty gains for the year. The financial sector has also outperformed most other sectors this year.

So let's look at two ETFs that investors could consider to gain exposure in the broad financial sector.

The Financial Select Sector SPDR ETF , which charges investors just 18 basis points in fees and expenses, is the most popular ETF available to investors in the financial-equities space.

It has a huge asset base of around $15.5 billion and tracks all the financial stocks from the S&P 500 Index as represented by the S&P Financial Select Sector Index. It has a portfolio of around 83 stocks. However, investors should note that all of these 83 stocks belong to the large-cap universe. This large-cap cushion significantly reduces the risk factor for an already volatile sector ETF.

Unsurprisingly, the ETF has a huge allocation to diversified finance companies and banks -- its top three holdings are Berkshire Hathaway, Wells Fargo, and JPMorgan Chase, each accounting for around 8% of the fund. The fund's financial constituents have come a long way since the subprime mortgage crisis and made significant strides toward full recovery.

Are the dark days over yet?
Efficient cost-control mechanisms, declining levels of loan writedowns, and a marked decrease in provisions for loan losses have helped pad the income statements of most financial companies. Further, adequate levels of capital being maintained by banks (even more than the regulatory requirements of the Basel Accords) have gone a long way in strengthening and stabilizing the balance sheets of financial companies.

And given the discipline most companies have shown in improving the quality of their loans, this trend of strengthening their balance sheets is most likely to continue going forward.

Low interest rates? Not a problem anymore
While low rates have led companies to borrow more, they've also cut banks' profit margins on their loans. Rising rates could help boost banks' net interest income, justifying the big jumps in their stocks recently.

This makes the prospects of the ETF quite exciting going forward, as it will not only help the financial companies in its portfolio boost their earnings but also help bring down their valuations, which have accelerated a lot since the surge in their stock prices.

Another niche segment
Moreover, beyond the Financial Sector SPDR ETF, I find the iShares U.S. Broker-Dealers ETF even more appealing. It tracks the performance of investment services companies and manages an asset base of around $152 million.

The ETF has a concentrated portfolio of around 23 stocks. Therefore the benefit of diversification against company-specific risks that you expect from most ETFs is somewhat diminished in this product. A high expense ratio of 0.45% is also a mark against it.

However, the ETF has been one of the favorites among investors this year. It has not only posted above-par returns, but has also outperformed its banking counterparts by a wide margin, which I believe more than compensates for the high expense ratio it charges.

One of the major reasons for this outperformance is the fact that the business of brokers-dealers and other financial intermediaries have been flourishing on account of higher brokerage fees and investment management income as trading activities at both the institutional and retail levels witness an uptick.

Going forward, this trend is likely to continue, as the bullish sentiment in the stock market is likely to sustain making the prospects for the brokers-dealers business as well as the ETF extremely lucrative.

The following chart compares the performance of the two financial ETFs with the SPDR S&P 500 ETF . As we can see, the two ETFs have comfortably outperformed the broader markets over the past year.

XLF Chart
XLF Chart

XLF data by YCharts.

The bottom line
Financials are by far one of the most economically sensitive sectors, making them slightly riskier in nature. Given their cyclicality and vulnerability, many investors tend to shy away from them.

However, the sector has also exhibited immense discipline and resurgence while treading the path to recovery after the financial meltdown. Nevertheless, financials surely seem poised for a further surge, even from their somewhat elevated current levels, and these ETFs surely are great ways to play this red-hot sector.

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