Significant Factors Impacting Financials – ETF Plays to Consider

by ETF Base on June 30, 2010

Financial ETFs have been among the most volatile sectors over the past few years, with the sector swinging from near complete collapse to euphoria over year over year comps for earnings (any positive earnings announcement compared to a year ago multi-billion dollar loss looks great).  With the the investment banks especially, able to borrow from the Fed (taxpayers) at near 0% and lend it at 6% or invest it at an even higher rate [Goldman Sachs (GS) went an entire quarter without a single losing day on trading operations], it’s no wonder that investors were piling into Financials.

More recently however, there’s still constant tinkering and probably a Part Deux to FinReg, the housing market’s a mess, unemployment is going nowhere fast and the Euro has only taken a breather from its likely implosion, so Financials are still very likely to move in a rapidly volatile fashion; the question is which way.  While mortgage rates are amazing low (current rates are at an all-time low in fact), it’s evident that buyers are questioning whether it’s even worth buying at any rate. Rates could go even lower rendering a rush into the market now futile, and people are starting to learn about restraint and frugality in the New Normal.  Also, as is usual, both sides of the political spectrum are at the extreme on the Financial Regulation Reform Bill.  Some say it’s going to destroy competitiveness in the US financial sector while others say it’s toothless and will be business as usual.

With that in mind, it’s first worth evaluating what some of the major Financial ETFs are to consider and then how to play them.

Key Financial ETFs and Strategies

1.  Financial Select Sector SPDR (XLF) – For a straight bullish play on the Financial sector without any leverage, XLF is a prominent ETF.  The top holdings are the usual big names you see in the headlines (usually negative press these days) like Goldman Sachs (GS), JP Morgan (JPM) and Citigroup (C).

Strategy – Long large banks/investment banks with no particular play on smaller/regional banks.  The thinking here is that FinReg is in fact toothless and the large will continue to get larger while pushing out smaller banks.

2. SPDR KBW Regional Banking (KRE) – Conversely, this ETF is devoid of the large insurers and investment banks and top holdings include unkowns like Fulton Financial Corporation (FULT), Bank of Hawaii Corporation Comm (BOH), Old National Bancorp Capital (ONB).

Strategy – Long small banks thinking that Financial Regulation is going to put constraints on the large players that don’t exist on the small ones and they were unfairly beaten down due to “guilt by association” but Fin Reg wasn’t really targeting these smaller regionals that didn’t dabble so much in CDOs, derivatives and taxpayer bailouts.
Strategy #2 – For investors unsure of which direction the sectors may go, but feel regionals will outperform, a pairs trade is always an option.  Long KRE/Short XLF.  This would mute a massive downtrend or uptrend and deliver some moderate gains as long as KRE did in fact outperform on either the upside or downside.

3. Direxion Daily Financial Bull 3X Shares (FAS) – For the extreme risk-seekers, there’s always leverage.  That’s what got us into this mess in the first place right?  Without bothering to even consider a 2X daily return fund, FAS is the 3X Daily Long Financials ETF.  The top holdings are very similar to XLF, but the returns are triple what the daily returns are, so on a daily basis they track hand in hand.  But let’s face it, retail investors aren’t using them the way they should.  They’re scratching their heads at the end of a week when XLF is flat at FAS is down 4%.  To understand this phenomena fully, read up on leveraged ETF decay.  For this reason, I’m not a huge fan of retail investors using leveraged ETFs but they’re worth mentioning for day traders.

Strategy – Short term (on the order of a few days) long FAS to exploit burst in the underlying Financial sector.  The sector tends to trade up on any positive news on both the political front or also, jobs, housing, earnings, further Fed delays in interest rate hikes or any excuse to move upward for that matter.

4. Vanguard REIT Index ETF (VNQ) – Real Estate Investment Trusts have rocketed back from the brink and they carry hefty yields to boot given the 90% payout provision.  This ETF spreads the risk around and carries a nice yield of ~4.5% as well.  For higher yields approaching 9%, consider individual issues (full REIT List of dozens of publicly listed companies in the segment).

Strategy – Long VNQ banking on either continued stability or improving conditions.  Regardless of broad market direction, the high yield and diversification is likely to deliver above market returns.  Note however that solvency concerns will arise if credit conditions deteriorate again and VNQ could be more volatile than the market at large.

Personally, I’m relatively agnostic on financials and don’t condone one strategy over the other necessarily.  There are so many different options available to get involved in the financial industry ranging from being a factoring broker to some of the ETFs cited above. But I wouldn’t be surprised to see the base XLF and other higher beta options more so, very far removed from current levels by Fall.

Disclosure: No long positions in any ETFs covered.  Author does have a hedged short position involving FAS.

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