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The Best ETF Sector Idea for 2010

Scott Burns

Scott Burns: The best sector ETF pick for 2010? My money is on regional banking. Hi there. I'm Scott Burns, Director of ETF Research for Morningstar. And I think that the best sector ETF pick for 2010 is going to be SPDR KBW Regional Banking, ticker KRE.

Joining me to help explain what's going on in regional banking and what's back my thesis is Morningstar Associate Director of Banks and Financials, Matt Warren. Matt, thanks for joining me.

Matt Warren: Good to be here.

Burns: Well, before we get into what's on the outlook for 2010, let's talk about 2009 a little bit in regional banking. And actually, 2009 was really a down year for the regional banking sector. The sector as a whole posted a negative 20% return. While when we look at broader financial sector ETFs, they actually had a positive 20% return. So, it was a pretty big split.

What happened there? What's some of the explanation to that?

Warren: Sure. If you look at the biggest banks, they got crushed very soon in the cycle, very early, because they had a lot of securities that had to be written down. They had a lot of consumer exposure that hits first. So, they had really gotten dinged first.

Whereas, the regional banks, they tend to have more commercial exposure, more commercial real estate exposure that kind of lags and those are the problems that we're seeing develop now more so.

Burns: So it was really more of an issue that the broader banks took a lot of their pain in 2008. The regional banks didn't start to feel that until 2009.

Warren: That's right. Plus too, the larger banks are benefiting from their investment banking units. Which profitability actually increased quite a bit after Lehman and Bear Stearns and some other capacity was taken out of the system.

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Burns: So, when we look forward to 2010, there are some risks. I think especially when we look at the consumer and how that affects commercial real estate. What's your outlook right now for regional banks going into 2010?

Warren: The consumer losses have still been mounting, but we expect those to peak relatively soon, the next couple quarters let's say. And then, if you look at the commercial book, commercial real estate in particular, there's an awful lot of problems there. The prices have been bid way up. There's a lot of loose lending. And now, you see the reverse of that.

You're seeing a lot of, especially recent vintage, deals that are well underwater. And that's where the problems are concentrated. The problems looked enormous if you go back to the March timeframe, when the economy was going off the tracks as well. Now that the economy is getting better, we actually think that some of the commercial real estate problems are going to be easier to work out than they would have been otherwise.

So if you look at the system as a whole, there's going to be losses. But it's not going to be a complete catastrophe.

Burns: Well, that's good. So, when we look at the state of the balance sheets there, is there anything, any red flags, anything that really jumps out? The system, overall, for regional banks; how does it look?

Warren: I think there's been a lot of capital brought into the system, dividends have been cut, banks been retaining capital. The healthier banks have been able to continue earning money. Some of the more troubled banks have been losing money and depleting their capital base.

So it's really a mixed bag. But, I think we're approaching the peak losses in consumer. The commercial real estate losses will peak sometime in the next year or 18 months. And the healthier banks are going to be able to work their way through this and get back to normalized earnings in probably a year, two years, somewhere in that timeframe.

Burns: Right. And if we look at anywhere in the broader financial sector, buying right before those peak losses hit turned out to be really the best time to get in.

Warren: That's right. So, there's been a lot of short term investing in banks over the last three years really; people chasing and trying to get ahead of their earnings curve. To the extent that you can buy before the change in earnings and stick with a bank that's not going to fail or massively dilute itself, that's been a winning strategy so far.

Burns: Yeah. The old "darkest before the dawn" adage, I guess.

Warren: That's right.

Burns: Well Matt, thanks for joining me with your insights. Again, our best ETF sector pick for 2010 is SPDR KBW Regional Banking, ticker KRE. I'm Scott Burns, Director of ETF Research with Morningstar. For this and other ETF news, please check out Morningstar.com's ETF center and Morningstar's ETF investors newsletter.