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The finan­cial sec­tor is one of four sec­tors to earn our “dan­ger­ous” rat­ing and is the worst-ranked sec­tor in the our 3Q11 Sec­tor Roadmap (pdf) report.

Typ­i­cally, when a sec­tor gets a dan­ger­ous rat­ing, we can find no attrac­tive ETFs in that sec­tor. How­ever, the finan­cial sec­tor ETFs (pdf) are tricky. There is one attractive-rated ETF, Pow­er­Shares KBW Prop­erty & Casu­alty Insur­ance Port­fo­lio (NYSEARCA:KBWP) and 21 dangerous-or-worse rated ETFs.

The main take-away is avoid all finan­cial sec­tor ETF except for KBWP. In fact, two of the finan­cial sec­tor ETFs are among the worst of all 400+ ETFs we cover. Both of these ETFs get our “very dan­ger­ous” rating:

  1. SPDR KBW Bank ETF (NYSEARCA:KBE)
  2. iShares Dow Jones U.S. Regional Banks Index Fund (NYSEARCA:IAT)

The fig­ure below illus­trates why the finan­cial sec­tor is tricky. Though the sec­tor is heav­ily weighted toward dangerous-or-worse-rated stocks (66% of the value of the sec­tor), attractive-or-better-rated stocks make up 15% of the sector.

With only 95 out of 557 finan­cial stocks get­ting an attractive-or-better rat­ing, there are not as many good stocks to choose from as there are stocks to avoid.

Hence, the “dan­ger­ous” rat­ing for the sec­tor does not nec­es­sar­ily mean there are no good stocks or ETFs in the sec­tor. It means the like­li­hood of them is low. So, investors must tread carefully.

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

click to enlarge

Sources: New Con­structs, LLC and com­pany filings

My reg­u­lar read­ers are aware of some of the worst stocks in the finan­cial sec­tor, namely Cit­i­group (C – very dan­ger­ous rat­ing) and Mor­gan Stan­ley (MS – dan­ger­ous rat­ing). Click here for my recent arti­cle on C and here for the arti­cle on MS. As noted above, there are a num­ber of attractive-or-better-rated stocks in the sec­tor, such as Aflac Inc (AFL – very attrac­tive rat­ing) and The Trav­ellers Com­pa­nies (TRV – attrac­tive rating).

Fig­ure 2: Hold­ings Count of Energy Sec­tor ETFs

click to enlarge

* # of Hold­ings excludes cash

Sources: New Con­structs, LLC

Fig­ure 2 shows clearly shows that not all Finan­cials 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.

Con­se­quently, it is impor­tant to derive a pre­dic­tive rat­ing for ETFs based on analy­sis of the under­ly­ing qual­ity of earn­ings and val­u­a­tion of the hold­ings in each ETF.

Fig­ure 3 shows how the 26 finan­cial sec­tor ETFs stack up ver­sus each other, the over­all sec­tor and the S&P 500 based on their risk/reward rat­ings and the allo­ca­tions to their hold­ings by rating.

Fig­ure 3: Invest­ment Merit Based on Hold­ings and Allo­ca­tions

* % may not add up to 100% due to the exclu­sion of cash and hold­ings not in our cov­er­age universe.

Sources: New Con­structs, LLC; and com­pany filings

Attrac­tive ETFs:

KBWP earns an attrac­tive rat­ing and there­fore, is the only finan­cial sec­tor ETF we recommend.

Neu­tral ETFs:

[[PIC]], REM, KCE and [[IAK]] allo­cate their value in a way that earns them a neu­tral rat­ing. We rec­om­mend investors buy the very attrac­tive and attrac­tive stocks in this sec­tor before buy­ing any of the U.S. equity finan­cial sec­tor ETFs except for KBWP.

Dan­ger­ous ETFs:

We rec­om­mend investors sell or short [[KIE]], [[FXO]], [[IAI]], [[PFI]], [[IYF]], [[UYG]], [[FFL]], [[RYF]], [[FAS]], IYG, [[XLF]], [[RWW]], [[PJB]], [[VFH]], [[PSCF]], [[KRU]], [[KRE]], [[KME]], [[QABA]], [[IAT]] and KBE because of their dangerous-or-worse rating.

Method­ol­ogy

Our analy­sis is based on aggre­gat­ing results from our mod­els on each of the com­pa­nies included in every ETF and the over­all sec­tor (557 com­pa­nies) based on data as of July 12, 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.

Given the suc­cess of our rat­ing sys­tem for indi­vid­ual stocks, we believe its appli­ca­tion to groups of stocks (i.e. ETFs and funds) helps investors make more informed ETF and mutual fund buy­ing deci­sions. Barron’s fea­tured our uniquely pre­dic­tive ETF research in “The Dan­ger Within”.

Dis­cloaimer: I receive no com­pen­sa­tion to write about any spe­cific stock, sec­tor or them.

Source: Don't Gamble in Financial Sector ETFs