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By Robert Goldsborough

After years of underperformance, the battered United States financial sector has been off to a strong 2013, driven by continued good news from the housing industry and more gains from the stock market. But many of the same headwinds facing the sector are unchanged--starting with continued low interest rates (which will remain so for the foreseeable future) and the lower interest-rate-spread revenue that banks have accepted. Added regulation has meant another layer of costs for financial services companies, and counterparty relationships with European banks could mean losses for U.S. banks if Europe's banking system collapses.

Despite these headwinds, we see some attractive drivers that could continue giving a lift to the financial sector, even if rates remain low. Further macroeconomic improvements and lower unemployment rates should increase borrowing and repayment rates. Banks have cut costs in other places, including reducing staff and branch locations, which we believe could offer better operating leverage as the economy improves. And a better economy also could boost investment banks' financial advisory and equity trading businesses. And all of this is merely a prelude to the improved spreads that the financial services sector could begin enjoying once interest rates begin rising, which could happen as soon as a year and a half from now.

For those investors who are comfortable with all of the above risks and are interested in a basket of U.S. financial companies, the exchange-traded fund Financial Select Sector SPDR (NYSEARCA:XLF) is an appropriate tactical satellite holding, offering broad U.S. financial services sector exposure.

The index that this exchange-traded fund seeks to replicate defines the financial services sector broadly to include commercial banks, diversified financial services firms, capital markets companies, insurers, REITs, and consumer finance firms. The result is a market-capitalization-weighted portfolio of 80 firms with a certain amount of concentration, as XLF's top 10 holdings make up slightly more than 50% of its assets.

The financials sector offers high beta exposure to the U.S. economy. The reason is that even seemingly small changes in unemployment and consumer confidence can have an outsize impact on loan repayment rates and the willingness to borrow. Other aspects of the economy, including the health of the housing market and even the shape of the yield curve, can provide headwinds or tailwinds for financial firms.

In recent years, owning XLF has required investors to be comfortable with far more volatility as a whole. Indeed, XLF's 31.8% volatility of return over the past five years has been some 41.0% greater than the S&P 500 Index's 18.9% volatility of return. An investor in this fund should have a high risk tolerance but could benefit from positive trends that may continue in the near term, including an improving macroeconomic environment, a further strengthening in the housing sector, and a continued strong equity-market performance.

This ETF offers the diversification that we think is prudent in a sector where some aspects of companies' operations are so opaque that it can be difficult to gauge their true risk exposure. One need look no further than the multi-billion-dollar trading loss at JPMorgan (NYSE:JPM) in 2012 to understand the perils of single-stock investing in the financial services sector. XLF's comprehensive sector portfolio mitigates company-specific risk while offering pure exposure to the U.S. financial services industry. We believe this ETF is an effective tool for investors seeking to overweight the financial sector within a broadly diversified portfolio.

Fundamental View
A variety of factors has continued to pressure U.S. banks' profitability. The big story has been low interest rates. Interest-rate-spread revenue at most U.S. banks has stayed the same or has fallen, and with rates expected to stay low for some time to come, bank margins will remain pressured. Some other issues negatively affecting U.S. banks in recent periods have included increased regulation that has blocked deposit-taking banks from engaging in proprietary trading, limited debit-card fees, higher compliance costs, and high unemployment, which generally tends to keep borrowing and repayment rates low.

The news hasn't been all bleak. To manage expenses better in a low-rate environment, U.S. banks have begun cutting staff and branch locations. And stress tests show that U.S. banks generally are better capitalized than in the past and can withstand serious economic shock. Banks even have enjoyed solid fee income from the mortgage-refinancing boom, although Morningstar's equity analysts are concerned that this has entirely been played out. A stronger housing market also could mean lower default rates and higher valuations of banks' mortgage-backed securities.

For investment banks, low interest rates and better credit spreads led to significant debt-underwriting activity in 2012. Going forward, a stronger economy should help investment banks' financial advisory and equity trading businesses.

At life insurers, persistently low interest rates also have been a headwind, as insurers' economic capital levels have fallen to new lows. Investors interested in the space should be aware that life insurers have taken several steps that are worth watching closely. For one, they're looking beyond traditional insurance toward alternative businesses such as corporate pensions and asset management. They also are likely to boost their allocations to risky assets such as high-yield bonds and illiquid investments in pursuit of higher returns.

One other issue facing XLF relates to European banks. European-domiciled financial firms make up a minuscule 1.4% of the assets of this ETF. However, problems with Europe's banking system could have a contagion effect on large U.S. banks, because European banks are their counterparties. As such, if Europe's banking system declines and its banks are unable to honor some of their obligations, we may see U.S. banks stuck absorbing some of the losses.

Based on Morningstar equity analysts' fair value estimates of the fund's underlying holdings, XLF is currently trading at 97% of its fair value, compared with 98% for the S&P 500. As a result of the aggressive steps banks took to recapitalize in the wake of the financial crisis and conservative underwriting over the past few years, capital ratios are improving.

Portfolio Construction
The fund employs full replication to track the S&P Financial Select Sector Index, which includes all financial stocks in the S&P 500. This modified market-cap-weighted benchmark limits individual constituents to 23% of the index, and the sum of securities whose weights are greater than 4.8% cannot exceed 50% of the index. These limits allow XLF to qualify as a regulated investment company. S&P rebalances the index quarterly.

Fees
The fund's 0.18% expense ratio is lower than its closest peers'. Its high trading volume and deep asset base keep its bid-ask spread tight. State Street engages in share lending, the practice of lending out the fund's underlying shares in exchange for a fee. It passes 85% of the gross proceeds to investors, which partially offsets the fund's expenses.

Alternatives
Vanguard Financials ETF (NYSEARCA:VFH) dips further down the market-cap ladder to offer broader exposure to the U.S. financial industry. It owns all 500 financial-services firms in the MSCI US Investable Market 2500 Index, including mid- and small-cap companies. VFH is also less top-heavy. Its top 10 holdings account for 35% of the portfolio. This better diversification gave VFH a slightly less volatile profile than XLF over the past five years. Yet, during that time, these funds were nearly perfectly correlated. VFH charges 0.19%. iShares Dow Jones US Financial Sector (NYSEARCA:IYF) also offers a broad portfolio of 250 financial services firms, but its 0.47% fee makes it less appealing. Over the past five years, IYF and XLF were nearly perfectly correlated.

Investors looking for more direct exposure to U.S. banks and less exposure to nonbank financial institutions might consider SPDR S&P Bank ETF (NYSEARCA:KBE). This fund offers equal-weight exposure to 39 U.S. banks, with more than two thirds of the portfolio invested in small- and mid-cap companies. KBE charges 0.35%.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: Stronger Equity And Housing Markets Give Boost To Financials