Financial ETFs To Avoid If Interest Rates Stay Low [Select Sector Financial Slct Str SPDR Fd, SPDR KBW Capital Markets (ETF)]

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October 28, 2014 4:36pm NYSE:BDCS NYSE:KCE

ratesAfter a tough first quarter, the U.S. financial sector started gaining momentum only to slow down in the third quarter. Soft trading volumes, weak mortgage banking activities, high legal costs and sluggish consumer and corporate activities


during the first quarter had paved the way for modest improvements in the banks’ core businesses during the second quarter.

Though some of the positive trends were carried into the second half of the year, the ongoing low interest rate environment has raised concerns about the profitability of the banks and is making the operating environment somewhat difficult for banking companies.

In fact, the deepening concerns have caused huge outflows from the Financial Select Sector SPDR (NYSEARCA:XLF) – the most popular and the largest ETF in the financial sector.

Investors have pulled roughly $913.3 million from XLF during last week – the biggest withdrawal in a week since 2009, as per a Bloomberg article.

Banks had earlier expected that the end of QE would lead to higher interest rates. Though the Fed is expected to wrap up its bond buying program this month, we might continue to see the interest rates at rock bottom levels for some more time to come.

This is especially true as weaker-than-expected global growth might influence the Fed to slow the pace of ultimate rate increases, as pointed by the Federal Reserve Vice Chairman Stanley Fischer.

These global growth fears have led to increased activity in the U.S. treasury market causing rates to continue to slide.  In fact, the 10-year U.S. treasury which was trading around the 2.54% level as of September 26, has now plunged to near the 2.27% level.

Falling yields have led to a narrowing spread between long- and short-term rates, thereby hurting the net interest margin earned by banks. Moreover, many market experts believe that mergers and acquisitions have probably peaked and might slow down going forward.

This is expected to hit bank earnings as they generate fees from providing financial advice to these companies. Also, we have seen weak growth and beat ratios in Q3 relative to what we have been seeing in other recent quarters.

Given these concerns, financial ETFs might not continue with their out performance as they did last year. Below we have highlighted three financial ETFs which currently have a Zacks ETF Rank #4 or Sell rating. Investors should clearly avoid these ETFs as they are expected to underperform the broader markets in the near term.

SPDR S&P Regional Banking ETF (KRE)

This is one of the largest and the most popular ETFs in the regional banking space with an AUM of nearly $2.1 billion and average daily volume of roughly 3.4 million shares.

The product follows the S&P Regional Banks Select Industry Index, charging investors 35 basis points a year in fees. The product holds a well-diversified basket of 83 stocks. It uses an equal-weighted strategy and hence minimizes concentration risks.

The fund had provided a meager 1.3% in the past one year and has lost 6.2% in the year-to-date frame (read: Avoid Regional Bank ETFs on Fed’s No Rate Hike Stance).

UBS ETRACS Linked to the Wells Fargo Business Development Company Index ETN (BDCS)

This product tracks the Wells Fargo Business Development Company Index, intended to measure the performance of all BDCs. The benchmark consists of about 32 companies in total, all of which have a focus on the U.S. market.

The note focuses on pint-sized companies although it is somewhat concentrated as the top three holdings — American Capital, Prospect Capital and Ares Capital — make up for nearly 10% share each.

Investors should note that BDCS is structured as an ETN which means that it has the credit risk of UBS but does not suffer from tracking error or complicated tax treatments either. It has amassed just $71.3 million in its asset base. Total trading cost is pretty high as the expense ratio came in at 85 bps while volume is light, suggesting wide bid/ask spreads.

The note has an impressive yield of 7.93% but has lost 5.6% this year.

SPDR S&P Capital Markets ETF (KCE)

KCE tracks the S&P Capital Markets Select Industry Index, holding 44 stocks in its basket. Sector-wise, asset management & custody banks take the top position in the basket at 60% while investment banking & brokerage takes the remaining share.

With respect to holdings, Janus Capital Group Inc., Legg Mason Inc. and Goldman Sachs Group Inc. take the top three spots. It charges an expense ratio of 35 basis points and has lost 5% in the year-to-date frame.

This article is brought to you courtesy of Zacks.


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