A Rough Road for Financial-Services ETFs

In the first half of 2014, the market performance of the U.S. financial-services sector trailed the broader U.S. equity market by several hundred basis points.

Thus far this year, there have been some small bumps in the road for a sector that has enjoyed a robust comeback during the past five years, but where volatility remains meaningfully high and uncertainty even higher. While no one doubts that large banks, which dominate the financial sector, are far better capitalized than they were heading into the financial crisis, the final results in March of the Federal Reserve's annual stress test on the United States' 30 largest banks demonstrate both a lack of robustness on the part of some large lending institutions--including  Citigroup (C)--as well as the clear presence of a prominent headwind in the form of elevated compliance, regulatory, and legal costs across the industry.

Another headwind is the U.S. economy. While it unquestionably has shown some bright spots during the past several years, concerns about a less-than-strong economy generally has weighed on banks, which feel less inclined to lend in such an environment. Less lending means less growth for banks.

The Opportunity in U.S. Financial Services
Morningstar's equity analysts view the financial-services sector as largely fairly valued, with pockets of opportunity in individual stocks. A future rally in the sector likely would be driven by several factors, including continued improvement in the U.S. economy (and likely, overseas economies as well), which would in turn prompt central banks to continue pulling back on their "easy money" policies and instead allow for interest rates to rise. That likely would mean greater lending from banks, as well as lower global unemployment. At the same time, global markets would need to continue their march upward (Morningstar's equity analysts hold the view that the financial-services industry's asset managers' performance more or less will follow the market). And, in theory, continued strong markets would bring more deal activity for investment banks. On top of all this, banks likely would continue their ongoing cost-cutting efforts (we view many physical bank branches as endangered species).

Unpacking Specific Subsectors' Performance
Broadly, the financial-services sector breaks down into a handful of subsectors, which include banks, insurance firms, REITs, and asset managers/capital markets. Banks have underperformed the overall U.S. equity market thus far this year, amid stress-test results and a general sector rotation away from financial services. Insurance firms also have lagged amid strong debt and equity markets, which tend to force down insurers' prices and thus returns on invested capital. Meanwhile, REITs have done very well after a not-so-great 2013, during which investors panicked. Although one might think that the specter of rising rates would hurt REITs, rising rates also usually mean a strong economy, and for REITs, a boom means higher occupancy and steadily increasing rents on tenants.

A Closer Look at an Array of Financial-Services ETFs
Some of Morningstar's own proprietary data points can help investors make sense of the many exchange-traded funds out there that are devoted to the financial-services sector. First, we will apply some of these data points to a group of broad-based, market-capitalization-weighted financial-services ETFs. Next, we will take a closer look at strategic-beta financial-services ETFs, global and foreign financial-services ETFs, and the narrowly constructed ETFs devoted to several financial subsectors. Finally, we'll examine recent trends in fund flows in the financial-services sector.

An Overview of Market-Cap-Weighted Financial-Services ETFs
There are three large and liquid cap-weighted financial-services ETFs:  Financial Select Sector SPDR (XLF),  Vanguard Financials (VFH), and  iShares U.S. Financials (IYF). All seek to replicate broad indexes of the largest U.S. financial stocks, including diversified financial-services companies, banks, REITs, insurers, and capital markets firms. All have relatively similar portfolios, although there are small differences in composition. 

The table below provides more details on the three funds:

Fidelity recently launched a broad-based, cap-weighted financial-services ETF, Fidelity MSCI Financials Index (FNCL), with a rock-bottom expense ratio of 0.12%. Although the fund has had some success gathering assets ($121 million as of this writing), the three larger broad financials ETFs dwarf FNCL in terms of assets and liquidity.

PowerShares S&P SmallCap Financials (PSCF) is another market-cap-weighted ETF devoted to the financial sector. As its name suggests, PSCF tracks an index of small-cap U.S. financial-services companies. It takes its holdings from the S&P SmallCap 600 Index. In the Morningstar Style Box, PSCF falls within the core-value segment, between micro-cap and small cap. Morningstar does not compute a price/fair value ratio or an Economic Moat Rating for PSCF. The ETF has lagged cap-weighted financial ETFs during the past year, although its performance has been in line with those funds over the trailing three-year period. PSCF's expense ratio is 0.50%.

 

Data Points
Valuation-wise, investors could benefit from looking first at price/fair value ratios. One of the most useful data points for ETF investors is Morningstar's fair value estimate, which leverages the bottom-up fundamental analysis produced by our global team of equity research analysts. Our equity analysts evaluate the value of a business using our discounted cash flow model, which calculates the present value of a company's future discretionary cash flows based on its cost of capital, as determined by our analysts. Our per-share fair value estimate represents the aggregate, asset-weighted fair value estimate of the stocks in an ETF's portfolio that are covered by Morningstar equity analysts, divided by the ETF's number of shares outstanding. Our equity analysts may not cover each of the stocks in an ETF's portfolio, so we assume the stocks that aren't under coverage trade at fair value.

Looking at the three market-cap-weighted financial-services ETFs, we see that they all trade at ratios greater than one, which indicates that the portfolio may be overvalued. XLF trades at 101% of fair value, VFH trades at 102% of fair value, and IYF trades at 101% of fair value. So the three big cap-weighted financial-services ETFs do not trade at any kind of discounts to their fair values.

When evaluating ETFs, another useful data point is the economic moat rating, which helps establish the quality of a fund's underlying portfolio. Morningstar's equity analysts evaluate firms' competitive advantages, or the barriers that a company builds around itself, as well as how long we believe the company can sustain that edge over its competitors. Our equity analysts spend a great deal of time evaluating and debating the strength and sustainability of a firm's competitive advantage and examining its returns on invested capital before assigning it to one of three moat sizes: wide, narrow, or none. Wide-moat companies all tend to have at least one strong sustainable competitive advantage (many have several) and earn ROICs well in excess of their cost of capital. Narrow-moat firms, by contrast, are ones that may not be able to continue generating hefty ROICs as competition heats up over the long haul.

In any sector, there's a broad mix with all kinds of moat sizes. However, a portfolio with a large percentage of companies with narrow and wide moats is one that we would categorize as high-quality. The bulk of the assets in large, market-cap-weighted financial-services ETFs are invested in narrow-moat companies. For example, 19% of XLF's assets are devoted to wide-moat companies and 61% are invested in narrow-moat firms. The ratios are similar for VFH, which invests 13% of its assets in wide-moat companies and 50% in narrow-moat firms, and for IYF, where the breakdown is 20% and 49%. Clearly, the large market-cap-weighted financial services ETFs are fairly high-quality portfolios, although anywhere from 10% to 15% of assets are invested in companies with no competitive advantages whatsoever.

Strategic-Beta Financial-Services ETFs
There are several good-sized ETFs devoted to the financial-services sector that seek to improve their return profile relative to traditional market benchmarks. Morningstar terms this category of funds "strategic beta." Here are three strategic-beta ETFs devoted to the financial-services sector that we believe are worth discussing.

The first, Guggenheim S&P 500 Equal Weight Financial (RYF), tracks an equal-weighted index of 84 stocks. As is the case with other equally weighted funds, RYF offers more of a small- and mid-cap tilt than its market-cap-weighted peers. For example, 35% of RYF's portfolio consists of mid-cap names, compared with just 9% of XLF and 21% of VFH. RYF is only slightly more volatile than its cap-weighted counterparts. RYF has meaningfully outperformed its cap-weighted brethren over the trailing one-, three-, and five-year periods. RYF's position in the style box is almost identical to that of VFH; both funds fall between medium and large and near the boundary of core value and core. RYF also invests in a significant number of high-quality financials firms. In fact, just 18% of RYF is devoted to companies with no economic moat. RYF charges 0.40% and trades at 103% of fair value.

First Trust Financials AlphaDEX (FXO) tracks a fundamental index that uses a proprietary stock-selection methodology to rank financials firms on both growth and value factors. As a result, FXO's portfolio differs meaningfully from many of its sector-ETF peers. The index rebalances quarterly and takes valuation into account when rebalancing. As a result, FXO sits squarely in the center of the core-value band in the style box, while the cap-weighted financials ETFs--and RYF--all sit at or near the border between core value and core. FXO's portfolio also has more of a small- and mid-cap tilt than its competitors, with fully 57.5% of assets invested in mid-cap firms and another 15.0% devoted to small-cap companies. FXO has meaningfully outperformed the cap-weighted U.S. financials ETFs over one-, three-, and five-year periods, and it has done so with slightly less volatility than the cap-weighted funds. FXO charges 0.70%.

Finally, PowerShares KBW High Dividend Yield Financial (KBWD) is a concentrated, higher-risk but higher-yielding financial industry ETF that tracks a dividend-yield-weighted index containing small- and mid-cap financials firms like banks, insurers, and equity and mortgage REITs. In the style box, KBWD is squarely in the deep-value region, between micro-cap and small cap. It has no direct peer. Morningstar's equity analysts don't cover enough of its holdings for us to have an estimate of fair value for the fund or a moat rating. And the fund only has traded for about three and a half years, so it has less performance history than some other financials ETFs. However, KBWD has meaningfully lagged its traditional cap-weighted peers over the trailing one- and three-year periods. The ETF yields about 8% but charges a pricey 1.55%.

 

Global and Foreign Financial-Sector ETFs
Investors looking for exposure to financial-sector firms outside of the U.S. have several options. One is to consider an ETF holding global financial-services names. IShares Global Financials (IXG) is one such option. IXG devotes about 41% of its assets to U.S. companies, with most of the remaining assets invested in companies based in developed foreign markets, such as Banco Santander, Commonwealth Bank of Australia, and Royal Bank of Canada.

IXG has posted meaningfully higher volatility during the past five years (19.9%) relative to its U.S.-only financial-sector ETF peers. At the same time, IXG charges 0.48%. IXG's performance is highly correlated with the three large U.S.-only financial-services ETFs (92% to 93% during the past five years). As a result, cost-conscious investors looking for financial-services sector exposure might prefer XLF or VFH, which carry expense ratios of 0.16% and 0.19%, respectively.

Other ETF options for investors seeking access to financial-services companies from outside the U.S. include iShares MSCI Europe Financials (EUFN), the very small SPDR S&P International Financial Sector (0.50%), and even First Trust STOXX European Select Dividend Index Fund (FDD) (0.60%). However, it's important to note that while FDD has a large tilt toward financials companies (40.5% of assets), it also holds European dividend-paying companies from other sectors as well.

Sub-Sector-Level Financial-Services ETFs
Investors with a strong conviction about an individual subsector within U.S. financial services can consider ETFs devoted to banks, REITs, or insurers. Banking firms have lagged the U.S. financials sector thus far this year in the wake of the mixed results from the stress tests. The largest and most liquid broad-based banking ETF is  SPDR S&P Bank (KBE), which charges 0.35%. Investors interested solely in regional banks can consider  SPDR S&P Regional Banking (KRE) (0.35%), iShares U.S. Regional Banks (IAT) (0.46%), or PowerShares KBW Regional Banking (KBWR) (0.35%).

REITs have performed very well thus far in 2014, enjoying a recovery after investors panicked in 2013. The market for REITs came back after investors acclimated to the notion of the Fed potentially winding down quantitative easing. And investors' bullishness comes from the signaling effect that would be inherent in higher interest rates--namely, that rates tend to rise when an economy is strong. REITs are cyclical by nature, and with a boom would come higher occupancies and the ability for REITs to steadily increase building rents. Investors interested in REIT ETFs should consider  Vanguard REIT (VNQ) (0.10% expense ratio),  Schwab US REIT (SCHH) (0.07%),  iShares U.S. Real Estate (IYR) (0.44%), and  iShares Cohen & Steers REIT (ICF) (0.35%).

Insurance companies have lagged the broader market in 2014. The reason is that as the capital markets have done well--both stock and bond markets have rallied--insurance companies' book values have gone up. That has resulted in declining customer prices and as a result, lower ROICs for insurers. Several suitable insurance-sector ETFs are SPDR S&P Insurance (KIE) (0.35% expense ratio) and iShares U.S. Insurance (IAK) (0.46%).

Flow Trends
A look at where fund flows have been going often can help give investors some insight into what other investors are thinking. Recent fund-flow data for financial services show several noteworthy dynamics. First, strategic-beta ETFs devoted to the financials industry have enjoyed strong inflows during the past year, owing to their track records of outperformance and a generally increased focus from investors and advisors on strategic-beta funds. Next, most regional-bank ETFs have had significant inflows during the past year but outflows year to date. Also, there have been meaningful flows into financial-services industry ETFs devoted to European financial companies.

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