Nothing But Ugly Financial Sector ETFs

by: David Trainer

We rec­om­mend investors short the KBW Bank ETF (KBE) and avoid or sell all other finan­cial sec­tor ETFs. We also rate the invest­ment merit of the top nine finan­cial sec­tor ETFs.

Per our first-quarter-2011 review of U.S. Equity Sec­tor ETFs, the finan­cial sec­tor is one of two sec­tors that gets our “dan­ger­ous” rat­ing. Per Fig­ure 2, the finan­cial sec­tor has only 95 stocks (17% of the value) that we rate attractive-or-better, com­pared to 323 stocks (66% of the value) that we rank dangerous-or-worse.

Some good stocks in the finan­cial sec­tor to buy indi­vid­u­ally or as part of an ETF are The Trav­ellers Com­pa­nies (TRV) and Cap­i­tal One Finan­cial (COF). Some stocks to avoid, sell or short in the finan­cial sec­tor are Mor­gan Stan­ley (MS) and Citigroup (NYSE:C).

Investors eye­ing finan­cial sec­tor ETFs should be care­ful. The sec­tor offers more stocks with bad invest­ment oppor­tu­nity than good. The invest­ment merit of each ETF derives from its con­stituents, so ETFs that over­weight attractive-or-better-rated stocks-- like TRV and COF-- can be great invest­ment oppor­tu­ni­ties, while ETFs that over­weight neutral-or-worse-rated stocks-- like MS and C-- should be avoided.

Fig­ure 1: Finan­cial Sec­tor – Cap­i­tal Allo­ca­tion & Hold­ings by Risk/Reward Rating

Sources: New Con­structs, LLC and com­pany filings

When ana­lyz­ing the finan­cial sec­tor ETFs, we started by iden­ti­fy­ing those ETFs with accept­able struc­tural integrity as mea­sured by XTF, an ETF research firm. We chose the 6 ETFs whose XTF rat­ing was above the sec­tor aver­age XTF rating.

Fig­ure 2: Finan­cial ETFs With Accept­able Struc­tural Integrity

Sources: New Con­structs, LLC; XTF and com­pany filings

Fig­ure 2 shows clearly that not all finan­cial ETFs are made the same. Dif­fer­ent ETFs have mean­ing­fully dif­fer­ent num­bers of hold­ings, and there­fore, dif­fer­ent allo­ca­tions to hold­ings. Given the dif­fer­ences in hold­ings and allo­ca­tions, these ETFs will likely per­form quite differently.

After deter­min­ing the struc­tural integrity, we ana­lyzed the invest­ment merit of each ETF based on how it allo­cated value to each stock it held. Fig­ure 3 shows how the 6 finan­cial sec­tor ETFs stack up ver­sus eachother and the over­all sec­tor based on their over­all risk / reward rat­ings and the allo­ca­tion of their hold­ings by rating.

Fig­ure 3: Invest­ment Merit Based on Hold­ings and Allocations

Sources: New Con­structs, LLC; XTF and com­pany filings

Attrac­tive ETFs:

We find no attractive-or-better-rated finan­cials sec­tor ETFs.

Neu­tral ETFs:

We also find no neutral-rated finan­cials sec­tor ETFs. We rec­om­mend investors buy the very attrac­tive and attrac­tive stocks in this sec­tor before buy­ing any of the finan­cials ETFs we cover in this report. Con­tact us for the full list of 95 finan­cials com­pa­nies that earn an attractive-or-better rating.

Dan­ger­ous ETFs:

We rec­om­mend investors avoid or sell short KIE, [[KCE]], VFH, [[IAI]], XLF, [[IYG]], [[KBE]], [[RKH]], and KRE because of their dangerous-or-worse ratings.

Bench­mark Comparisons Sec­tor Benchmark

The over­all finan­cials sec­tor out­per­forms KIE in qual­ity of earn­ings rat­ings. The sec­tor earns a very attrac­tive eco­nomic vs. reported earn­ings rat­ings com­pared to KIE’s neu­tral rating.

KIE out­per­forms the over­all finan­cials sec­tor in val­u­a­tion rat­ings. KIE has a price-to-EBV of 0.6, earn­ing it a very attrac­tive rat­ing com­pared to the finan­cials sector’s price-to-EBV of 1.4. KIE’s GAP of 47 years earns it a dan­ger­ous rat­ing while the finan­cials sector’s GAP of 65 years earns it a very dan­ger­ous rating.

Click to enlarge

KIE allo­cates cap­i­tal more effec­tively than the over­all finan­cials sec­tor. Per Fig­ure 3 above, KIE allo­cates 35.6% of its value to attractive-or-better-rated stocks while the sec­tor only allo­cates 16.6%. KIE also only allo­cates 43.7% of its value toward dangerous-or-worse-rated stocks com­pared to the sector’s dangerous-or-worse weight­ings of 65.8%.

For expla­na­tion and details behind our risk/reward rat­ing sys­tem, see one of our Com­pany Val­u­a­tion reports, which are avail­able for free here.

Mar­ket Benchmark

The S&P 500 sig­nif­i­cantly out­per­forms KIE in all com­po­nents of the Over­all Risk/Reward Rat­ing except for Price-to-EBV. KIE’s rel­a­tively low Price-to-EBV does not off­set its sig­nif­i­cantly worse qual­ity of earn­ings rat­ings and other val­u­a­tion ratings.

The S&P 500’s market-weighted aver­age ROIC is 18.3%, earn­ing it a very attrac­tive rat­ing com­pared to a dangerous-rated 7.1% for KIE. The S&P 500 also has a very attrac­tive eco­nomic vs. reported earn­ings rat­ing because its eco­nomic earn­ings are pos­i­tive and ris­ing while KIE’s eco­nomic earn­ings are negative.

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The S&P 500 allo­cates cap­i­tal more effec­tively than KIE. Per Fig­ure 3 above, the S&P 500 allo­cates 42.3% of its value to attractive-or-better-rated stocks while KIE only allo­cates 35.6%. The S&P 500 also only allo­cates 23.7% of its value toward dangerous-or-worse-rated stocks com­pared to KIE’s dangerous-or-worse weight­ings of 43.7%.


This report offers rec­om­men­da­tions on Finan­cials sec­tor ETFs and bench­marks for (1) investors con­sid­er­ing buy­ing finan­cials sec­tor ETFs and for (2) com­par­ing indi­vid­ual ETFs to the finan­cials sec­tor and the S&P 500. Our analy­sis is based on aggre­gat­ing results from our mod­els on each of the com­pa­nies included in every ETF and the over­all sec­tor (531 com­pa­nies) based on data as of April 19th, 2011. We aggre­gate results for the ETFs in the same way the ETFs are designed. Our goal is to empower investors to ana­lyze ETFs in the same way they ana­lyze indi­vid­ual stocks.

To make an informed ETF invest­ment, investors must consider:

1) The struc­tural integrity of the ETF and its abil­ity to ful­fill its stated objec­tive. We use XTF, an ETF research firm, to find the top nine ETFs with the best struc­tural integrity rating.

2) The qual­ity of the ETF’s hold­ings. We deter­mine an ETF’s qual­ity using our stock ratings.

Disclosure: I am long TRV.