The financials crashed and burned during the 2008 meltdown but have since been in recovery mode with the rest of the market. This article will explore the risks and rewards associated with these Financial ETFs to identify which have been the best performers.
There are about 40 ETFs focused on financial firms and but I have limited my analysis to those that have at least a 3 years history and also have a daily average trading volume of at least 50,000 shares. I will look first at ETFs that cover the entire financial landscape and then narrow down to a few more specialized ETFs.
Overall Financial Sector. The overall financial sector includes commercial banks, brokerage houses, insurance companies, consumer finance firms, and Real Estate Investment Trusts (REITs). On a cap weighted basis, the big players are Berkshire Hathaway Class B (BRK.B), JP Morgan Chase (JPM), Wells Fargo (WFC), Citigroup (C), and Bank of America (BAC). The ETFs that cover the full range of financial firms are:
- Financial Select Sector SPDR (XLF). This is the most liquid financial ETF, trading over 50 million shares per day. This is a cap weighted fund comprised of 80 firms, with the top 10 holdings making up about 50% of the total assets. The expense ratio is a low 0.18%.
- Vanguard Financial (VFH). This ETF is cap weighted but is broader based than XLF. VFH is comprised of 520 firms across entire the financial spectrum but the top 10 holdings still account for 35% of the total assets. As is typical with Vanguard funds, this ETF also has a low expense ratio of 0.19%.
- iShares Dow Jones US Financial Sector (IYF). This ETF provides a broad exposure to US financial firms. It has 261 holdings and is similar to VFH in that the top 10 holdings represent about 39% of the total assets. Large-cap companies comprise 73% of assets, mid-cap firms about 22%, and small-cap companies the other 5%. It has a relative high expense ratio of 0.46%, making it one of the most expensive financial focused ETFs.
- iShares S&P Global Financials (IXG). This ETF offers exposure to global financials, with non-US stocks making up over 57% of the assets. For the foreign portion of the portfolio, Australia companies are the most represented followed by the United Kingdom and Canada. This fund has a high expense ratio of 0.48% but it is one of the few funds that providing exposure to foreign financial companies.
- iShares Dow Jones US Financial Services (IYG). This ETF has 110 cap weighted holdings with banks representing 56% of the total assets and other financial services (like credit card companies) comprising the other 44%. The top two holding, JPM and WFC, make up over 20% of the total assets. The expense ratio is a relatively high 0.47%.
- First Trust Financial AlphaDEX (FXO). This ETF tracks the StrataQuant Financial Index, which is a proprietary algorithm that selects financial stocks from the Russell 1000. Stocks are ranked and weighted based on growth and value factors. The ETF holds 164 companies and the constituents are re-evaluated quarterly. It has a high expense ratio of 0.70%.
Banking Sector. The banking sector includes regional banks as well as the "too big to fail" mega banks. It does not include non-bank financial assets such as REITs and insurance companies. The profitability of banks is generally vulnerable to economic conditions. For example, a small increase in unemployment can have large impacts on loan repayments. Over the last few years, low interest rates and regulation have generally been a drag on profits. On the plus side, banks are now well capitalized and the boom in mortgage refinancing has been a steady source of income. The ETFs in this sector are:
- SPDR S&P Bank ETF (KBE). This is an equally weighted ETF holding 40 companies. Due to the equal weight, mid-cap and small-cap companies make up over 70% of the total assets. It has a fee of 0.35% which is relatively low for this subsector.
- SPDR S&P Regional Banking (KRE). This ETF focuses on the smaller regional banks serving local retail customers and businesses. The regional banks typically specialize in a particular geographic area. This is an equal weight funds with 76 holdings. About 60% of the assets are invested in small-cap companies. Like KBE, this fee has a relatively low 0.35% fee.
- iShares Dow Jones US Regional Banks (IAT). This is a cap weighted ETF holding 62 companies. The bulk of the assets are invested in so called "super-regional" banks such as US Bancorp (USB). This fund has an expense ratio of 0.47%.
Insurance Sector. This sector offers policies that protect individuals and companies from risk of loss for covered events. The sector includes property and casualty insurance as well as life and health. The only ETF that meets my criteria for this sector is:
- SPDR S&P Insurance (KIE). This is an equal weight ETF with 46 holdings that covers all insurance related businesses. It has a relatively low 0.35% expense ratio.
Broker-Dealer Sector. This sector includes a broad range of financial related firms including investment banks such as Goldman Sacks (GS), retail brokers such as Charles Schwab (SCHW), exchanges like CME Group (CME), and market specialist like Knight Capital (KCG). The only ETF that meets my criteria for this sector is:
- iShares Dow Jones US Broker-Dealer (IAI). This ETF has 22 cap weighted holdings. The top 10 holdings consume over 60% of the total assets. The expense ratio is 0.47%.
To evaluate the risks and rewards of these financial ETFs, I plotted the rate of return in excess of the risk free rate (called Excess Mu on the charts) versus the volatility of each ETF. For comparison with the overall stock market, I have also included the SPDR S&P 500 ETF(SPY). The results are shown in Figure 1 and were generated using the Smartfolio 3 program (smartfolio.com). The ETFs in the overall financial sector are plotted as "blue dots", banks are plotted as "red dots", the broker-dealer ETF is an "orange dot", and the insurance ETF is denoted by a "green dot". SPY is plotted as a "green diamond".
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Figure 1: Reward and Risk for Technology ETFs (3 years)
Figure 1 indicates that there has been a wide range of returns and volatilities associated with financials. Generally, over the past 3 years, the financials have not been good performers relative to the S&P 500. The financial ETFs have been more volatile than the SPY and have also generated less return; not a good combination!
However, looking only within the group of financials, FXO has been an excellent performer with a higher return and less volatility than the other financial funds. The regional banking fund, KRE, had a high return but also a high volatility. Was the increased return associated with KRE worth the increased volatility? To answer this question, I calculated the Sharpe Ratio for each ETF.
The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. On Figure 1, I also plotted a red line that represents the Sharpe Ratio of the XLF. If an asset is above the line, it has a higher Sharpe Ratio than the XLF. Conversely, if an asset is below the line, the reward-to-risk is worse than the XLF.
Some interesting observations are apparent from the plot. First, the overall financial ETFs are bunched closely together with the exception of the global financials which had poorer performance and the AlphaDEX ETF which had better performance. Of the banks, KRE had the best Sharpe Ratio by far. The insurance ETF also had good relative performance but the broker-dealer ETF had a relatively poor Sharpe Ratio. In my opinion, over the past 3 years, the "best" financials ETFs from a reward-to-risk are FXO, KIE, and IYF.
Risk versus reward is one dimension of a portfolio but how about diversification? To assess diversification, I calculated the correlation coefficient for every pair of assets mentioned in this article. As you might expect, financial ETFs are highly correlated with one another, with correlation coefficients ranging from 87% to over 99%. In addition, over the last three years, financials have also been highly correlated with SPY, with coefficients generally over 85%. Thus, my conclusion was that the financial ETFs have not provided a high degree of diversification.
Over the past year, financials have been in a strong bull market. To determine how this sector performed relative to the SPY over the recent past, I generated another plot with a one year look back period. This is shown in Figure 2 and as you might have expected, there have been significant changes.
Figure 2: Reward and Risk for Financial ETFs (1 year)
What a difference a year has made! The financials as a group have generated better returns with less risk over the past year than they did over the 3 year period. Over the past year, the financials have also handily beaten the S&P 500. However, on the negative side, the financial ETFs have remained highly correlated with one another.
As seen from the plot, the financials are tightly grouped in terms of reward and risk but FXO, KIE, and IYF have continued to offer superior performance. An unexpected result is that the broker-dealers ETF, IAI, has moved to the forefront and has offered an excellent Sharpe ratio (likely due to increased trading associated with the bull market).
Which are the best financial ETFs? It depends on the time period but my vote goes to FXO, KIE, and IYF, which have been standout performers over both time frames.
The financials are a dynamic group with generally high volatility. Over the last year, the reward has outweighed the risks but beware that when investing in these ETFs, you should have a high tolerance for risk and be prepared for an exciting ride.