Bank on These ETFs

10/13/2015 9:00 am EST


Mark Salzinger

Editor and Publisher, The No-Load Fund Investor

Financial services stocks have outperformed the broader market over the past five years, yet the sector has a lower average valuation than the broader market, notes Mark Salzinger, editor of The Investor’s ETF Report.

Here, we examine the fundamentals and outlook for financials stocks and consider the best ETFs for exposure to them.

SPDR Select Sector Financials (XLF) and Vanguard Financials (VFH) are the best choices for broad exposure to financials.

Over the past three years, the annualized returns of XLF and VFH (17.6% and 16.5%, respectively) have topped those of the S&P 500 (12.1%) by wide margins.

Recently, the average price:earnings ratio on 2015 earnings for SPDR S&P 500 SPX was 18.7, while XLF’s P/E was just 14.9 and VFH’s was just 15.6.

Equally important, the long-term expectation for earnings growth in the financial sector is just as strong as for the broader market.

Why do financials have a discounted valuation despite superior performance and a comparable outlook? Sour sentiment, as investors remain wary of the regulatory climate around financial companies.

However, we believe that much of the impact from these requirements has already occurred and is adequately reflected in their share prices.

Investors also have worried over the effect of higher interest rates on the performance of financial services companies.

We think such fears also are overdone. Even if interest rates increase, they will remain at a level that is low on both an absolute basis and an historical one.

Plus, some financial companies will benefit from higher interest rates, particularly insurance companies.

The strength of the US economy will have a far greater impact than any other factor on the health of the financial sector. Fortunately, the economy has continued to perform fairly well.

XLF invests in a market-capitalization weighted portfolio of the financial services stocks in the S&P 500, so it is heavily oriented toward large-caps.

VFH offers a more inclusive market-cap weighted portfolio, of which about two-thirds are large-caps.

The largest proportions of XLF and VFH are devoted to banks, insurers, and real estate investment trusts (REITs).

We include XLF in our Opportunistic Best Buys model, but a small position in either ETF is likely to do fine over the next few years.

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