Can Bank ETFs Make A Comeback?

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November 25, 2013 5:38pm NYSE:FAZ NYSE:KBWB

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.

Morgan Stanley takes the top spot in terms of assets at 9.4%, while another in-focus bank, Goldman, assumes the third spot with more than 7.0% exposure. State Street – a stock with reaffirmed rating – took the second spot with above 8% weight to round the top three. The fund charges an expense ratio of 0.35% a year.

In terms of performance, this fund was up about 1.87% in the trailing three-day period despite the downgrade of two key elements. In the first nine months of the year, the fund gained 29.4%. KBWC also carries a Zacks ETF Rank #2 with a Medium risk outlook.

Other Choices

The other two products IAI and IYG – both of which are exposed to GS, MS and JPM – delivered a return of around 0.8% and 0.6% in the concerned period while in the last one-year period (as of September 30, 2013) IAI shot up 50.6% and IYG posted an impressive 34.4% return.

Both these iShares funds charge 0.45% in fees per year. While IAI has a Zacks ETF Rank #2 with Medium risk outlook, IYG has a Zacks ETF Rank #3 (Hold) with a Low risk outlook.

Bottom Line

The financial sector has lost some luster but is still in demand. Investors can still count on the sector which is likely to return to revenue growth next year. Bullish Zacks ETF Ranks for most of the funds are also supportive of this view.

Moreover, financial institutions which are more into the broker-dealer/capital markets segment might get their share of aid next year, if not in December, when the ‘taper talk’ resumes in all likelihood. Thus, there are clearly plenty of drivers in store for the sector to make up for the disappointment created by Moody’s downgrade.

This article is brought to you courtesy of Eric Dutram.

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