Financials ETFs Drive the Market, Unfortunately

By Will McClatchy, ETFzone.com

Wednesday, February 25, 2009

Financials. The mere mention of the word makes investors wince. Avoiding them is not unreasonable, but to ignore them would be a mistake because they drive so much of market activity. When financials hit bottom, the bottom for the market as a whole can't be far away. Whether bullish or bearish on financials, investors will find numerous ETFs to execute any conceivable strategy.

The case for financials may be made from 1) the phenomenal drop in valuations coupled with regression to the mean, 2) the staggering amount of government aid handed to them and 3) signs of increasing stability and liquidity in bond markets. As weak as they may be, if the US and other governments continue to prop financials up, they should eventually recover and deliver reasonable returns to investors who buy them cheap. In the meantime volatility of financials make them ideal for the nimble trader.

The case against financials can be made from the fact that 1) big firms still have unknown quantities of toxic assets on their hands, 2) taxpayers may revolt at continuing bailouts, and 3) even if big banks recover, profit levels from the go-go expansionist years will not return for years or even decades. Huge derivatives positions at the biggest firms are hard to value and their refusal to disclose details does not make this task easier or inspire confidence. Even if these assets recover, from now on banks will have to rely on old-fashioned earnings of spreads between interest paid on deposits and interest earned on loans. Packaging loans into securities for Wall St. at huge profit is gone. And as to trading, many of the swings come from hard-to-forsee events such as disclosure of new toxic assets or a new government initiative, so traders cannot rely on hunches about macroeconomic trends.

Broad-based US financials have taken it on the chin pas the following table shows:

Returns in %	12 Months	3 Years
US Financial Sector (NYSEArca:IYF)	-62.14%	-29.83
Vanguard Financials (AMEX:VFH)	-60.82	-28.20
SPDR Financial (NYSEArca:XLF)	-66.81	-32.48

Between these three, IYF and VFH are very similar assemblages of large banks, insurance companies and other former powerhouses. Correlation reliably exceeds 95% and often approaches 99%. IYH's annual fees of .48%, therefore, seem pricey next to VFH's .25%. With fund returns differing by only few percentage points per year, the chance of IYF beating VFH on average given its .23% higher fees seems remote.

If any megasector calls for continued picking and choosing among subsectors, financials are the one. Main Street has fared far better than Wall Street and in fact has not trailed the overall market as badly as one might expect. Smaller regional banks, as can be see from a sampling of SPDR's subsector ETFs over the past year (through January 2009), held on to far more value during the past year's downturn than large national banks (KBE), brokerage houses (KCE) and insurance firms (KIE):

Returns	12 Months
SPDR KBW Regional Banking ETF (AMEX:KRE)	-44%
SPDR KBW Insurance ETF (NYSEArca:KIE)	-56%
SPDR KBW Capital Markets ETF (AMEX:KCE)	-62%
SPDR KBW Bank ETF (AMEX:KBE)	-67%

The above funds all sport .35% fees. A similar sector line is from iShares:

• iShares Dow Jones Regional Banks ETF (NYSEArca:IAT), annual fees: 0.48%
• iShares Dow Jones US Broker Dealers ETF (NYSEArca:IAI), annual fees: 0.48%
• iShares Dow Jones US Financial Services ETF (NYSEArca:IYG), annual fees: 0.48%
• iShares Dow Jones US Insurance ETF (NYSEArca:IAK), annual fees: 0.48%
• iShares FTSE NAREIT Mortgage ETF (NYSEArca:REM), annual fees: 0.48%

Diversified investors should remember that they already have direct exposure to financials through broad-based equity ETFs, and this is especially true for foreign markets. Financials make up about 20% of the MSCI EAFE Index (NYSEArca:EFA) and continue to dominate the iShares FTSE/Xinhua China 25 Index (NYSEArca:FXI) with 40% of that fund. In general Asia and emerging market financials are thought to have cleaner balance sheets than North America and Europe. (Financial firms make up about 13% of the SPY, down from over 20%). Most analysts expect foreign financials to emerge from the global recession without the same degree of damage as US firms.

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 are a host of products with a wide variety of slants. Almost all weight holdings based with formulas based on fundamentals of the companies themselves, such as revenue, dividends, 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 (AMEX:PFI), annual fees: 0.6%
• PowerShares Dynamic Insurance Portfolio ETF (AMEX:PIC), annual fees: 0.6%
• PowerShares Financial Preferred Portfolio ETF (AMEX:PGF), annual fees: 0.6%
• PowerShares FTSE RAFI Financials Sector Portfolio ETF (NasdaqGM:PRFF), 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 (AMEX:RYF), annual fees: 0.5%

Finally, several ETFs offer leverage for the careful trader. Typically they hold short-term futures to track daily returns either up or down. 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 (AMEX:UYG), annual fees: 0.95%
• ProShares UltraShort Financials ETF (AMEX: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 indexfunds.com, author of two books on investing, and founder of ETFzone.com, Will has been writing on indexing issues for 8 years. He holds an MBA from the University of Texas at Austin.