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ETF Specialist

An ETF for Low-Cost Exposure to Large-Cap Financials

With an interest-rate hike at the forefront, here's a closer look at an inexpensive financial-services exchange-traded fund.

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Speculation surrounding the timing of interest-rate hikes has been in the news in recent weeks. With quantitative easing in the rearview mirror and recent reports of economic weakness, there is a greater likelihood of the Federal Reserve raising interest rates sooner rather than later. With that in mind, one might consider taking a bullish view toward financial firms, given that large banks dominate the financials sector, and ongoing low interest rates have meant continued pressure on banks' net interest margins. While higher rates may well serve as a tailwind for financials firms over the longer term, any immediate benefit from an interest-rate hike for financial-services firms would be muted at best, as higher rates will not translate one-for-one into higher earnings for banks. Bank earnings and valuations are driven more by net interest margins, which are more stable over time, than by rates themselves. Morningstar's equity analysts don't expect interest-spread revenue at U.S. banks to grow anytime soon. Instead, they believe low loan yields will keep interest-spread revenue at the same level or even will decline.

Regardless of interest-rate uncertainty, the U.S. financial-services sector is one of the more attractively valued U.S. equity sectors at this time, trading at 95% of Morningstar's equity analysts' estimate of fair value. And for investors seeking broad exposure to the U.S. financial-services sector,  Financial Select Sector SPDR ETF (XLF) is a suitable option. Unlike many other U.S. equity sectors, the financial-services sector has not returned to its precrisis highs. The reasons for this have been well-documented, including greater regulation, continued ultralow interest rates, asset write-downs, and higher capital requirements.

The index that this exchange-traded fund seeks to replicate includes commercial banks, diversified financial-services firms, capital-markets companies, insurers, REITs, and consumer finance firms. The result is a market-cap-weighted portfolio of 87 firms that concentrates 48% of its assets in its top 10 holdings.

Financial companies are highly sensitive to small moves in the U.S. economy. The reason is that even seemingly small changes in unemployment and consumer confidence can have an outsize impact on loan repayment rates and the willingness to borrow. Other aspects of the economy, including interest-rate movements, the health of the housing market, and even the shape of the yield curve, can provide headwinds or tailwinds for financials firms.

In recent years, XLF investors have had to be comfortable with high volatility. Indeed, XLF's 17.4% standard deviation during the past five years has been some 35% greater than the S&P 500's 12.9% standard deviation during that same period. An investor in this fund should have a high risk tolerance and the patience to wait for trends such as an improving macroeconomic environment, a more robust housing sector, and continued strong equity market performance--a combination of which would benefit the sector.

This ETF offers prudent diversification in a sector where some aspects of companies' operations are opaque, making it difficult to gauge companies' true risk exposure. In 2012, for example,  JPMorgan (JPM) posted a multi-billion-dollar trading loss and its stock price declined almost 30% in less than two months; such single-stock dives are not uncommon in the financial-services sector. The fund's comprehensive sector portfolio mitigates company-specific risk while offering pure exposure to the U.S. financial-services industry. This ETF offers one-stop exposure to the largest financial-services firms in the sector and is suitable for investors seeking to overweight the financials sector within a broadly diversified portfolio.

Fundamental View
The U.S. economy has continued its slow recovery, with improving housing data, stabilizing manufacturing, and decent retail sales. In 2015's first quarter, the U.S. financial-services sector slightly underperformed the broader market after big banks fell a bit short, both on the revenue and expenses side at the end of 2014. Also weighing on financial stocks was ongoing margin pressure.

While large banks are far better capitalized than they were heading into the financial crisis, the March 2015 annual Federal Reserve stress test for the United States' 31 big banks still raised some concerns about some large lending institutions. While many big banks, including  Citigroup (C) (which had failed one of the tests in 2014), passed the stress test,  Bank of America (BAC) was ordered to resubmit its capital plan owing to some unspecified deficiencies. And as expected,  Deutsche Bank (DB) and Santander (SAN), which are the U.S. trust operations of major European banks, failed as well. In addition to those concerns, banks continue to face a prominent headwind in the form of elevated compliance, regulatory, and legal costs across the industry, which continue to hit banks' income statements. To counteract lower spread revenue and tighter margins, banks have continued to reduce expenses, including cutting staff and branch locations.

Elsewhere in the financial-services industry, investment banks and asset managers historically have followed the market. Investment banks have enjoyed strong underwriting volumes, and equity markets' strength has boosted the earnings of investment banks with asset-management businesses. One clear concern with investment banks is the possible impact of higher interest rates on debt underwriting, fixed-income trading, and the valuation of the banks' fixed-income securities. Certainly for asset managers, flows have tapered off, particularly in the fixed-income market.

XLF only holds one European-domiciled stock ( ACE Limited (ACE)), which makes up just 1.2% of assets. However, the fund still faces some risk from the continent. European economic problems could have a contagion effect on large U.S. banks, as European banks are their counterparties. As such, a continued inability to solve sovereign-debt problems in Europe could eventually cascade across the Atlantic, and we could see U.S. banks stuck absorbing some of the losses. That said, European banks are finally starting to catch up to their U.S. counterparts on the capital front, reducing this risk (although they still meaningfully lag U.S. banks).

Portfolio Construction
The fund employs full replication to track the S&P Financial Select Sector Index, which includes all financials stocks in the S&P 500. This modified market-cap-weighted benchmark limits individual constituents to 23% of the index, and the sum of securities whose weightings are greater than 4.8% cannot exceed 50% of the index. These limits allow XLF to qualify as a Regulated Investment Company. S&P rebalances the index quarterly.

The fund's 0.15% expense ratio is low. Its high trading volume and deep asset base keep its bid-ask spread tight. State Street engages in share lending, the practice of lending out the fund's underlying shares in exchange for a fee. It passes 85% of the gross proceeds to investors, which partially offsets the fund's expenses.

 Vanguard Financials ETF (VFH) dips further down the market-cap ladder to offer broader exposure to the U.S. financial industry. It owns all 556 financial-services firms in the MSCI U.S. Investable Market 2500 Index, including mid- and small-cap companies. VFH is also less top-heavy. Its top 10 holdings account for 34.5% of the portfolio. This better diversification gave VFH a slightly less volatile profile than XLF during the past five years. Yet, during that time, these funds were nearly perfectly correlated. VFH charges just 0.12%. Another large and liquid option,  iShares U.S. Financials (IYF), offers a broad portfolio of 279 financial-services firms but charges an unappealing 0.45% fee. During the past five years, IYF and XLF were nearly perfectly correlated.

A recently launched and very inexpensive option is Fidelity MSCI Financials ETF (FNCL), which charges 0.12%. However, FNCL has fewer assets than competing funds. FNCL tracks a slightly different index from Vanguard Financials ETF; FNCL tracks the MSCI USA IMI Financials Index, while VFH tracks the MSCI US Investable Market Financials 25/50 Index. As a practical matter, the indexes are very similar; the Fidelity ETF's benchmark has 514 companies, which is slightly less than the number of holdings found in the index that the Vanguard ETF tracks. Fidelity customers with a minimum balance of $2,500 can buy FNCL commission-free, although they are subject to a short-term trading fee by Fidelity.

Investors looking for more direct exposure to U.S. banks and less exposure to nonbank financial institutions might consider  SPDR S&P Bank ETF (KBE). This fund offers equal-weight exposure to 63 U.S. banks, with more than two thirds of the portfolio invested in small- and mid-cap companies. KBE charges 0.35%.


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Robert Goldsborough does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.