Doubling Down on Wall Street

09/29/2009 12:00 pm EST

Focus: ETFS

Scott Burns

Director of ETF Analysis, Morningstar, Inc.

Scott Burns, director of Morningstar’s Exchange Traded Securities Analysis and analyst John Gabriel find an ETF for investors seeking extra exposure to capital markets.

Investors seeking exposure to brokers, exchanges, and other capital markets facilitators might find iShares DJ US Broker-Dealers (NYSEArca: IAI) an interesting satellite holding.

The “broker-dealer” rubric covers a wide variety of firms. Indeed, the fund includes everything from name-plate Wall Street banks with big trading operations to retail and online brokers, exchanges, and market specialists.

The top ten holdings soak up approximately 60% of this cap-weighted ETF. Former pure investment banks Goldman Sachs Group (NYSE: GS) and Morgan Stanley (NYSE: MS) sit atop this portfolio, with weightings of about 12% and 8%, respectively. Leading online discount broker Charles Schwab (Nasdaq: SCHW), predominant futures exchange CME Group (Nasdaq: CME), and financial advisory platform Ameriprise Financial (NYSE: AMP) round out the fund’s top five holdings.

The index’s average market cap, on a holdings-weighted basis, is about $5.6 billion. Large-, mid-, and small-cap stocks comprise roughly 37%, 35%, and 28% of the portfolio, respectively.

Would-be investors should note that the performance of these firms is highly dependent on (and correlated with) the health of the broader capital markets. In fact, over the past three years, IAI has sported an 88% correla­tion with the Standard & Poor’s 500 Index. This is a significant stat, considering that only 2% of IAI’s portfolio is also included in S&P Depositary Receipts (NYSEArca: SPY). All in, this fund basically represents a levered play on the stock market.

While trading volumes help many of the firms in this ETF’s portfolio generate transactional revenue, many also rely heavily on fees tied to assets under management. Thus, in rising markets, asset-based revenues tend to bolster performance. However, the significant operating leverage inherent with this type of business model cuts both ways.

Clearly, investors should expect this fund to be much more volatile than the broader market. In fact, the fund’s three-year average annualized standard devia­tion clocked in at 31%—more than 50% greater than that of the S&P 500 over the same period.

Unfortunately, the negative impact of oper­ating leverage was on full display in 2008; IAI fell a whopping 60% in the year, while the S&P 500 experienced a (less painful) 37% decline. For the year to date, however, IAI has rebounded impres­sively as it has risen about 40% versus a roughly 15% rise for the S&P 500 through the end of August.

After a whopping 40% year-to-date increase, IAI’s portfolio is now fairly valued, according to our equity analysts’ aggregated fair value estimates.

This fund’s 0.48% expense ratio is slightly higher than the fee charged by its closest competitor, SPDR KBW Capital Markets (NYSEArca: KCE), which levies 0.35% per annum.

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