Can Bank ETFs Make A Comeback?

bankThough the financial sector has been one of the star performers so far this year, its growth momentum slackened in Q3 with 9.9% earnings growth. This was in stark contrast to 30% earnings growth seen in Q2 for financial equities. In fact, excluding Bank of America Corporation (NYSE:BAC), the sector’s Q3 earnings growth slipped to 3.3%.

Results from two industry bellwethers –J.P. Morgan (NYSE:JPM) and Goldman Sachs (NYSE:GS) – were underwhelming. If this was not enough, the credit-rating organization Moody’s (MCO) downgraded long-term senior unsecured debt of four top-tier U.S. banks including Goldman and J.P. Morgan, to add to the woes.

What’s Behind the Downgrade?

Apart from Goldman and JPM, Moody’s cut its credit rating by a notch for Morgan Stanley (MS) and the Bank of New York Mellon (BK).  As per the agency, the U.S. government might not be ready to intervene and bail out a stressed financial institution in any upcoming crisis as it did five years ago (read:Capital Market ETFs in Focus on Taper Talk).

This is because of the fact that regulatory instructions under the Dodd-Frank Act are against the taxpayer funded bailouts for rescuing a failed bank. The Dodd-Frank Wall Street reforms also limit banks’ ability to go for risky investments and urged institutions to be transparent in financial practices.

In the downgrade, the agency mostly considered the banks’ core health and ruled out any boost from the government. In such a scenario, debt holders of the said banks might have to bear the burden of a credit default in the future.

On a positive note, Moody’s reiterated the senior holding company ratings of Bank of America, Citigroup Inc. (C), State Street Corp. (STT) and Wells Fargo & Co. (WFC).

Market Impact 

This news led to some modest losses for the concerned companies. Shares of JPMorgan dipped 0.9% in after-hours trading, Goldman Sachs lost 0.2% while Morgan Stanley dropped 0.7%, on Moody’s announcement day.

All the aforementioned companies have considerable exposure in funds like the PowerShares KBW Capital Markets (KBWC), iShares US Broker-Dealers (IAI), iShares U.S. Financial Services ETF (IYG), and the PowerShares KBW Bank ETF (KBWB)).

While KBWC and IAI have 6%–8% exposure in Goldman and Morgan Stanley, KBWB and IYG put at least 8% assets in JP Morgan (read: Financial ETFs Tumble on Citigroup Warning).

While we do not believe that only the Moody’s announcement can hit the above-said financial sector ETFs which have sizeable exposure in better-rated companies as well, these could be the ones to watch out for following any unforeseen hit or miss in the financial sector:

PowerShares KBW Bank Portfolio (NYSEARCA:KBWB)

This ETF follows the KBW Bank Index and normally invests at least 90% of its total assets constituting the cap weighted index. With about two dozen financial stocks in its basket, the fund has so far amassed $168.8 million in assets. The ETF sees decent volume of about 130,000 shares a day and charges investors 35% of fees to own the fund.

In terms of holdings, KBWB is headed by Citigroup and Bank of America while the in-focus JP Morgan takes up the third spot. All three have over 8.0% of holdings in the fund. Large caps dominate the fund at roughly 80% of the total assets, while the portfolio definitely has a value tilt with more than 60% of the fund going to that type of security.

Following the Moody’s cut on November 14, the fund advanced only 0.14% while KBWB returned a massive 22.98% on a year-to-date basis (as of September 30, 2013).  The fund currently has a Zacks ETF Rank #2 (Buy) with a Low risk outlook (also read Top Ranked Financial ETF in Focus: KBWB).

PowerShares KBW Capital Markets (NYSEARCA:KBWC)

KBWC – a relatively less popular choice in the space – looks to track the KBW Capital Markets Index. This cap-weighted benchmark reflects the performance of businesses concerning broker-dealers, asset managers, trust and custody banks among others in the space. This fund also has a portfolio of two-dozen stocks and lighter volume of about 3,500 shares a day, along with AUM of just over $9.0 million.

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