IAI: Were the Broker-Dealers the First Financials to Bottom?

Financial stocks have been climbing from the depths of last year’s lows, and the shift has tugged funds like iShares Dow Jones US Broker-Dealers (IAI) back to the surface. While many of IAI’s components have been dramatically affected by the credit crisis, the fund offers investors exposure to the non-banking segment of the financial industry. Components like the New York Stock Exchange (NYX) and Intercontinental Exchange (ICE) stand to benefit from government efforts to improve the financial industry while not exposing investors to the lending risk that has plagued many banks. As investors clamor to partake in a financials rally while trying to limit their exposure to credit markets, IAI could continue its upward swing.

IAI’s performance, reflected in our momentum rankings, has been impressive year to date. According to Morningstar, the fund’s market return is more than 25% year to date, besting the S&P 500 by more than 20%. In the last month, IAI’s relative performance has been dramatic—the fund’s market return beat the S&P 500 by nearly 13%. In our Sector Momentum Tracker ETF rankings, the fund advanced from the No. 71 spot on February 10 to the No. 19 spot on May 5. The cringe factor comes into play when looking at the fund over a three-year annualized time frame, in which the fund underperformed the S&P 500 by more than 10%.

The image of broker-dealers has changed dramatically over the past few years. The image of the NYSE specialist, running about the trading floor frantically conveying trades, has given way to a 'Game Boy' age of traders, commandeering trading algorithms from their increasingly quiet outposts. While the thinning of the trading crowd can be witnessed on TV, the cutbacks and job losses are not a new phenomenon. As job losses mount in the broader economy, cutbacks in the broker-dealer industry may have been ahead of the curve. Before “economic crisis” became an everyday catch-phrase, broker-dealers pared back staff as a new hybrid age of trading took the stage. Soon after the NYSE commenced the early stages of its hybrid program in late 2006, large specialist firms like Labranche began trimming their ranks dramatically. By December of 2007, the NYSE had closed large sections of the trading floor.

IAI tracks the Dow Jones U.S. Select Investment Services Index. IAI’s underlying index aims to mirror the performance of the investment services sector of the U.S. equity market. Securities in the IAI basket include specialized financial services that can range from securities brokers and dealers to online brokers to securities or commodities exchanges. The fund’s average three-month trading volume is more than half a million shares, and volume seems to be picking up. IAI’s management fee is a low 0.48%.

While IAI helps investors access diversified financials and exchanges, the fund puts a lot of weight into top components. IAI’s top component, Goldman Sachs (GS), has a strong broker-dealer unit but also has significant exposure to credit risk. Nearly 63% of the fund’s assets are concentrated in the top 10 holdings, with more than 11% of the fund allocated to GS alone. Many of the good broker-dealer units featured in the IAI portfolio are tied to ailing lending units and to a credit crisis that may be slow to resolve.

Recent financial data has also indicated that broker-dealers have been requiring less direct government support. On Thursday, May 7, the Federal Reserve released data on direct loans from the Fed to U.S. banks and financial companies in early May. Statistics showed that on May 6 financing for primary dealers and other broker-dealers fell to $600 million from $700 million. As broker-dealers begin to gain traction, IAI could experience a concurrent shift in momentum. While financial news may be growing more positive, many investors are not yet ready to buy shares of GS or Morgan Stanley (MS) directly—making IAI’s exposure to a basket of 27 different equities all the more appealing.

The view from the floor of the NYSE has changed, but the significant layoffs by broker-dealers in 2007 and early 2008 have subsided as technology takes hold. Broker-dealers were forced to change and innovate fundamentally before the economic downturn gained momentum. In early March, Barclays released a research report suggesting that broker-dealers may have already seen the darkest days and, with the least amount of bad debt on their books, could be the first part of the sector to bottom. IAI could be the right ETF for those looking to participate in a financial sector upswing.

Comments

[Tony Roberts:]

Great insight. Hopefully Goldman will pay my tax dollars back soon.

May 13 09:12 PM

[aarc:]

Maybe, maybe not.

$XBD made 96% price appreciation trough to peak out of this recent rally while $BKX made off with 136%.

On the rally from 2002 to 2007; $XBD made off with more than 300% price appreciation. Is that not a bubble or what? That could mean excessive speculation on the brokers/dealers capacity/capabilities to generate income. Speculation with higher probability not based on fundamentals and then they suffered only 80% haircut in this downturn?

$BKX on the other hand made off with only 98% price appreciation on the same period. Is that a mania or not? Then they suffered 85% haircut since they are the center of this controversy.

Now consider this, since the electronification of trading, trading fees have substantially decreased with no other direction but down as competition gets stiffer. Likewise, with this stock market meltdown many traders and investors will be having lots of reservations entering the markets thus lower profits potential.

How about banking?

They can be considered dedo too with the fabled "American Consumerism" dead on the water.

One major factor not being considered for banks is that the government has sunk it's teeth too deep into the banking sector. If the banks don't make money and their problems got worse, the government will become the major casualty along with the banks.

I think the government will not allow that to happen. They left the Tech Sector to rot since 2001 when they proved to be nothing but hot air - and so they rotted in hell. Will the government shore up the $XBD members the way they do with the $BKX members or simply leave them on their own - let them rot if they prove to be nothing but hot air?

The government has the power to legislate that can favor one sector over the other such as making new trading protocols with China, India, Brazil, Russia, and the other developing countries including the Middle East and Africa.

Trading agreements that can considerably favor the major banks and thus shore up the $BKX into heights they can't possibly reach without a "lever" provided by the gov't.

There is still a big world out there. More than 2.5 billions of consumers in the BRIC and the developing countries that will require more infrastructures, roads and bridges, electrification systems, water supply systems, more brick and mortar housing projects to replace their mudhuts/bamboo houses, more shopping centers, more credit cards, more automobiles, washing machines, computers, etc.

They will also need a lot more agricultural and mining equipment, manufacturing plants, technological centers, and all those job creating industries needed to support billions of people as they become more hungry for material things that the western world has already taken for granted during the last 3 decades.

And they are still in their 20's to 40's unlike the few hundred million Western World's baby boomers who are going to enter their twilight years in the very near future.

Unless the brokers/dealers can make a foothold into the BRIC and the other developing countries and their stock markets, they will be left with what they have now.

May 14 01:43 AM