G20, Dodd-Frank Act Put Financial ETFs in Focus

Includes: EUFN, IAI, XLF
by: Michael Johnston

Financial stocks will be in focus in coming days, as investors digest financial reforms agreed upon by lawmakers in a bill known as the Dodd/Frank Act. These reforms were passed early Friday in what many are calling the most sweeping regulatory overhaul on the American financial system since the 1933 and 1934 Security Exchange Acts were instituted in the wake of the Great Depression. Among the biggest changes are new rules that will prevent banks from providing more than 3% of private equity and hedge fund capital; banks will also no longer be able to invest more than 3% of their tier one capital. There will also be a ‘bank tax’ to cover future bailouts, a new consumer protection agency, forced divestiture of derivatives, as well as a slew of other changes affecting virtually every sector of the financial industry. Despite the major changes, financial ETFs have shrugged off the news, with most funds posting modest gains in mid-Friday trading .

The regulatory changes may not be done, as the most powerful nations of the world meet this weekend in Toronto to discuss a variety of issues, with a likely focus on financial regulation. With the issue of China’s currency policies effectively addressed, regulation of the global financial system should dominate the G-20 meetings. The recently-passed financial reforms give President Obama great leverage in Canada this weekend; the president said that he would urge his G-20 colleagues this weekend in Toronto to “act in concert” to strengthen global oversight of the finance sector, so look for proposals of a global bank tax or stiffer regulation to be in focus.

With the new rules in place and possible new global regulations coming out of the G-20 meeting, look for the following financial ETFs to be in focus.

Financial Select Sector SPDR (NYSEARCA:XLF)

XLF holds some of the largest financial institutions in the world, tracking the Financial Select Sector Index. Many of these components will be impacted by the new regulations; top holdings include Bank of America (NYSE:BAC) (10.1%), Wells Fargo (NYSE:WFC) (9.7%), and J.P. Morgan (NYSE:JPM) (9.6%). It focuses on giant and large cap firms with those securities making up about 85% of the total assets of the fund. XLF is up slightly thus far in 2010, and had gained close to 2.6% in Friday afternoon trading.

iShares Dow Jones U.S. Broker-Dealers Index Fund (NYSEARCA:IAI)

Although often smaller than their retail banking counterparts in XLF, securities in this fund look to be especially impacted by the bill provisions limiting investment in hedge funds and private equity firms. These operations have been extremely profitable for IAI’s holdings in the post-financial crisis world; holdings include big brokers such as Goldman Sachs (10.4%) and Morgan Stanley (NYSE:MS) (8.4%). Due to trouble at Goldman, IAI has slumped thus far in 2010, posting a loss of 9.1% [see more on IAI's fundamentals]. However, the fund has picked up some steam on the financial reform news and was up 2.1% in Friday afternoon trading.

iShares MSCI Europe Financials Sector Index Fund (NASDAQ:EUFN)

Expect EUFN to continue its history of significant volatility after the G-20 meeting this weekend, especially given European financials’ potential impact on the sovereign debt crisis. EUFN tracks the MSCI Europe Financials Index, which is a free float-adjusted, market capitalization-weighted index designed to measure the combined equity market performance of the financials sector of developed and market countries in Europe. It is heavily weighted towards the UK (31.2%), while France, Switzerland, Spain, and Germany all receive allocations around 11% [see more on EUFN's holdings]. Some of its top individual holdings include HSBC (HBC) (12.3%), Banco Santander (STD) (6.7%), and BNP Paribas (OTCQX:BNPQY) (4.3%). EUFN has been among the worst performers in the financial sector, posting a loss of almost 15% since its inception earlier this year.

Disclosure: No positions at time of writing.

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