Banks have shown an impressive comeback following a series of hedging losses and scandals four years ago. The turnaround can be attributed to expense controls, sound balance sheets, and an uptick in mortgage activity and lower loss provisions.
Moreover, a favorable equity and asset market backdrop, falling unemployment, a solid housing sector and flexible monetary policy have been making the road to growth smoother.
Inside the Surge
Investors should note that the banking sector proved to be a good investment opportunity this past earnings season as well. The sector could maintain its relative strength attributable to strong banking numbers from most of the top financial stocks.
Big names like JPMorgan Chase (NYSE:JPM), Wells Fargo (NYSE:WFC) and Citigroup (NYSE:C) reported strong first quarter earnings while Bank of America (NYSE:BAC) was hurt by large mortgage-related losses and steep legal expenses.
Part of the reason for the solid performance of the banks is the Moody’s upgrade for the sector outlook to stable from negative. This was largely due to a revival in the economy, sustained GDP growth and improving employment conditions that are helping banks to sustain their balance sheet strength (read: 3 Sector ETFs Surviving This Slump).
Further, banks appear well positioned to face any economic downturn by reducing credit-related costs and restoring capital.
Concerns: Refinancing Slump and Interest Rate Hike
Despite strong optimism, the banking sector continues to face some serious challenges resulting from regulatory uncertainty, low interest rates and a sluggish loan environment.
A boom in mortgage refinancing, which has delivered strong profits for the U.S. banks over the past two years, began to wane due to a sudden spike in mortgage rates. The broad sell off in bonds last month, amid concerns about the Fed curbing its monetary stimulus, led to a surge in rates to 14-month highs, causing a drop in refinancing.
Investors should note that the big banks will be more vulnerable to this slowdown as these make up a large chunk of their business. During the first quarter, refinancing accounted for 87% of mortgage business at BAC, 90% at Citigroup, 77% at JPM and 68% at WFC.
Moreover, since the Fed could taper its bond buying program in the near future, concerns over rising interest rates are looming large. Though rising interest rates are expected to have a positive impact on the banks and increase interest income in the short term, this would discourage mortgage lending activity for the long term and cause losses in the securities portfolios of banks including JPM and BAC.
This is because many banks trying to protect their asset base have built capital reserves by adding big securities portfolios at very low rates. If the rate rises, book value of these securities will come down and in turn lower capital ratios (read: Banking ETFs: Laggards or Leaders?).
There is more though; less flexible business models (Basel III standard) are also major concerns for the U.S. banking firms. The implementation of Basel III requirements from this year will boost minimum capital standards. But adjusting liquidity management processes will cause a short-term negative impact on the financials of U.S. banks.
Bank ETFs in Focus
Amid weak fundamentals, banking ETFs would be facing tough times as we progress further this year and next year. Below we have highlighted three funds that provide exposure to the four bank giants, and thus could be ones to watch in the upcoming earnings season as well:
PowerShares KBW Bank ETF (NYSEARCA:KBWB)
The fund tracks the KBW Bank Index and charges 35 bps in fees and expenses. It is less popular with AUM of $135.6 million while volume is pretty good indicating a tight bid ask/spread.
The ETF holds a fairly small portfolio of 24 securities where the top four giants – BAC, C, JPM and WFC – together make up for nearly 36% of total assets. KBWB has exhibited strong performance as depicted by its returns of over 18% in the year-to-date time frame and over 39% in the trailing one-year period (read: What is Driving Bank ETFs Higher?).
Market Vectors Bank and Brokerage ETF (NYSEARCA:RKH)
The ETF follows Market Vectors US Listed Bank and Brokerage 25 Index and holds 26 most liquid securities based on market capitalization and trading volume. The fund allocates roughly 37% of the total assets to the four banking behemoths on a combined basis.
In terms of country exposure, the U.S. accounts for less than half of the share while Canada and United Kingdom get double-digit exposure at 14.6% and 13.4%, respectively. Despite holding liquid stocks from across the globe, the product has amassed only $16.8 million in its asset base. In addition, the fund is somewhat illiquid, possibly increasing the total cost beyond the expense ratio of 0.35%.
In terms of performance, the ETF added more than 10.5% year-to-date and over 38% over the trailing one-year period. RKH currently has a Zacks Rank of 3 or ‘Hold’ with a Low risk outlook.
iShares Dow Jones U.S. Financial Services Index Fund (NYSEARCA:IYG)
This fund tracks a broad benchmark of American financial corporations, holding 110 stocks in its basket. The four big players make up for the highest allocation with a combined 39% share.
From a sector perspective, banks account for roughly three-fifths of the assets while financial services take the remaining portion in the basket (read: 3 Top Ranked Financial ETFs to Buy Now). The product is relatively popular among investors having amassed over $491 million in AUM while it is a bit pricey charging 45 bps a year in fees. The ETF is relatively liquid compared to the Market Vectors counterparts.
The product has been quite strong, adding about 21.5% in the year-to-date time frame and over 49% in the trailing one-year period while paying out a yield just 0.94%. Currently, the fund has a Zacks ETF Rank of 3 or ‘Hold’ along with a Low risk outlook.
This article is brought to you courtesy of Eric Dutram.