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ETF Specialist

What's Under the Hood of Your Financials ETF?

We take a walk around the "always in the news" financials sector.

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Few corners of the market can draw such polarizing opinions as the financials sector. The now ubiquitous  Financials Select Sector SPDR (XLF), which we'll use as a proxy for the sector, shed more than 55% in 2008, making it--by far--the worst-performing sector in the S&P 500 Index, which was down about 37% for the year. Approaching the end of third-quarter 2009, still hardly a day goes by that the financials sector isn't grabbing headlines. With so much focus on this vital economic sector, we thought it might be helpful to "take a walk around the sector" and review the various ETFs that track financials firms.

The financials sector has been carved up relatively thinly by various ETF providers. The variety of ETFs covering financials affords investors flexibility to achieve their targeted exposure to this volatile basket. Broadly speaking, the areas within the financials industry include banking, insurance, capital markets, and real estate investment trusts. Even this is a rather sloppy segmentation, however, as within each of these industries there are multiple subindustries that can (and often do) have very different underlying fundamentals.

Consider this an introduction to the available investment options. Some investors might own a healthy dose of financials in anticipation of a recovery, but they may not be intimately familiar with their particular subindustry exposures. Likewise, there are likely those who've remained on the sidelines, waiting for the right opportunity to add financials exposure to their portfolios. As always, Premium Members can dig a bit further by checking out our Analyst Reports. For a free 14-day trial, click here.) For now, our goal is to familiarize investors with the various funds out there. As the ETF research team consistently reiterates, it's critical to look under the hood and understand what you own. That said, we'll be following up shortly with a more in-depth analysis of industries that constitute the financials sector. 

Broad Financials Sector ETFs
Beginning with the most widely diversified and commonly held funds, let's examine the differences in sector breakdowns between XLF,  Vanguard Financials ETF (VFH), and  iShares Dow Jones US Financial Sector (IYF). Of course, it is also important to review factors like liquidity, expenses, and dividend yields. First and foremost, we want to know the risk factors to which we might be exposing our portfolios.

Not surprisingly, banks sport the heaviest representation in these funds, representing roughly half of XLF and about 42% of both VFH and IYF. Insurance companies represent a decent portion of the broad financials ETFs, making up approximately 18%, 22.5%, and 20% of XLF, VFH, and IYF, respectively. Another industry representing a sizable stake in the sector is capital markets, which is made up of exchanges, brokers, asset managers, and former investment banks. This group soaks up about 19% of the assets in XLF and VFH and roughly 17% of IYF's assets. Lastly we have the REIT industry, which comprises just 7% of XLF, and approximately 12% of both VFH and IYF. While each of these industries performed similarly during the horrendous 2008 credit crunch (they all tanked), we'd be making a major mistake in lumping them together and assuming they all share the same risk/reward characteristics and long-term business outlooks. Let's peel back another layer and check out what lies within these financials industries.

Anyone who has followed the soap opera of the financials sector recently is likely well aware of the sharp dichotomy between "good" and "bad" banks. Thus, in cases where investors can confidently isolate the banks with relatively stronger capital positions and higher earnings potential, stock-picking might be the way to go (looking back on the crises, think  Wells Fargo (WFC) versus  Citigroup (C)). Still, banking is a wide umbrella; community, regional, and thrift banks operate much different (and simpler) business models than national money center banks like Citi or  Bank of America (BAC). The main differentiator is the diversity of operations in the national money center banks. While regional banks tend to focus on core banking (borrow on the short end of the yield curve and lend on the long end), the big boys have their hands in just about every financial-services industry including (but certainly not limited to) investment banking, wealth management, sales and trading, and so on. Needless to say, owning Citigroup in a portfolio carries a significantly different risk profile than owning say,  Bank of Hawaii (BOH).

Investors looking to "shake hands with the government" (ala Bill Gross) by owning "too-big-to-fail" institutions along with a sampling of large national and super-regional banks might look to  SPDR KBW Bank (KBE). (Note: Gross' comments were made with respect to explicit government guarantees on more senior assets and not on the common equity of these firms.) National money center banks and large regionals both make up roughly 47% of KBE's portfolio, with the remaining exposure to the credit services industry, by way of  Capital One (COF).

Looking beyond an ETF's label becomes more important as we move down the size spectrum toward regional and community banks. Investors would do well in understanding which geographic regions they might be exposed to when investing in smaller banking institutions. As it turns out,  SPDR KBW Regional Banking (KRE),  iShares Dow Jones US Regional Banks (IAT), and  PowerShares Dynamic Banking (PJB) all offer very different geographic exposures of which would-be investors should take note.

First off, if you're weary of loading up on banks with Pacific exposure, then steer clear of KRE. More than a fourth of KRE's assets operate in the Pacific region, whereas only 7% of IAT and 6% of PJB operate in the region. KRE is also relatively concentrated in the Southwest (26% of assets) and Northeast (19%). Don't go running full steam into IAT just yet, either. Investors should note that 38% of IAT's portfolio operates in the Midwest, compared with just 16% of KRE and 13% of PJB. Furthermore, more than 18% of IAT's portfolio is made up of money center banks, versus about 10% of PJB. Thus, of these ETFs, KRE is the only fund that doesn't hold stakes in large money center banks. Of course, for those who want nothing to do with any national banks or regional banks that might resemble them, the recently launched First Trust NASDAQ ABA Community Bank (QABA) could be an intriguing pick.

Capital Markets
Within capital markets, investors will find exchanges alongside brokers, money managers, and former investment banks.  SPDR KBW Capital Markets (KCE) and  iShares Dow Jones US Broker-Dealers (IAI) offers nearly identical exposure, with the exception that KBE includes a sampling of traditional asset managers (that is, mutual fund providers) in its mix.

Investors seeking exposure to brokers, exchanges, and other capital markets facilitators might find iShares Dow Jones US Broker-Dealers to be an interesting satellite holding. Holdings here include everything from nameplate Wall Street banks with big trading operations ( Goldman Sachs (GS)) to retail and online brokers ( Schwab (SCHW) and  E*Trade (ETFC)), exchanges ( NYSE Euronext (NYX)), and market specialists (LaBranche (LAB)). Would-be investors should note that the performance of these firms is highly dependant on (and correlated with) the health of the broader capital markets. In fact, over the past three years these ETFs have sported nearly 90% correlation with the S&P 500. This is a significant statistic considering that only 2% to 3% of these ETFs' assets are also included in S&P 500. All in, this slice of the financials sector basically represents a levered play on the stock market.

Within insurance, property and casualty insurers typically have very different fundamentals (and investment portfolios) than life and health insurers. Lump in the reinsurance firms, legacy asset managers, and insurance brokers, and we've got a pretty diverse group of businesses to sort through.

Life insurers have had a rough go as of late, partly because their annuity assets are generally invested in the stock market. By the same token, however, if the market can continue its impressive march upward, then the option value on these firms' investment portfolios could work in investors' favor. Interestingly, the best-performing insurance ETFs over the past year are the ones courting the lowest exposure to life insurers. Industry top performer PowerShares Dynamic Insurance (PIC) has just 3% tied to this subindustry, whereas SPDR KBW Insurance (KIE) and iShares Dow Jones US Insurance (IAK) have 22% and 23% of assets invested in life insurers, respectively. In the trailing 12 months through the end of August PIC, KIE, and IAK lost about 13%, 16%, and 26%, respectively.

REITs also come in various shapes and sizes, representing different parts of the economy. This traditionally stable asset class, which enjoyed years of easy access to credit and increasing asset prices, includes a broad swath of property types. These include hotels, health-care facilities, retail space, offices, industrial, and even mortgage assets. The most popular choices for REIT exposure include  iShares Dow Jones US Real Estate (IYR),  Vanguard REIT Index ETF (VNQ), and  SPDR Dow Jones REIT (RWR).

Something to consider here is that IYR contains mortgage REITs and more unconventional holdings like timber REITs and real estate services firms while VNQ limits itself to primarily conventional REITs. Subindustry exposures in this group of ETFs are surprisingly close, varying by a few percentage points at most. As such, we'd only point out that VNQ and RWR have exposures to retail properties of about 36%, compared with 31% for IYR. Also, health care, which is fundamentally in the strongest position of the various property types, makes up about 14%, 13%, and 11% of VNQ, RWR, and IYR, respectively. Interestingly, while assets and trading volumes are relatively scarce for more targeted REIT portfolios, iShares does offer ETFs that track NAREIT indexes covering Industrial/Offices ( (FIO)), Mortgages ( (REM)), Residential ( (REZ)), and Retail ( (RTL)) properties. Such fine slicing would be of little use to typical individual investors. But we can still analyze these portfolios to get a better grasp of how performance across different property types might vary.

Putting It Together
With a bit more familiarity of the various investment options in the financials sector, investors should be better prepared to put their respective thesis' to work. Without question, a tremendous amount of uncertainty remains for financials. In a forthcoming article, we'll revisit the different industries that make up the financials sector and discuss where we see the biggest risks and opportunities. With a firm understanding of the tools available to us, the goal is to construct more-flexible (or tailored) portfolios when it comes time to deploy capital. 

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Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

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