Banking ETFs 101 - ETF News And Commentary

The financial sector of the U.S economy has been one of the best performing sectors this year, both in terms of stock market performance as well as quarterly growth in earnings. A comparative analysis of State Street’s Global Advisor’s, Select Sector SPDRs (sector based ETFs) reveals that the Financial Select Sector SPDR (XLF) — an ETF which tracks the performance of financial stocks listed in the S&P 500, is up by 21.50% on a year-to-date basis as of September 25^th, 2012,  behind only Technology Select Sector SPDR (XLK) which has returned 22.65% for the same time period.

The performance of XLF gives a fair indication of the performance of the broader financial sector, as the ETF is considered to be a mirror image of the performance of the financial sector as a whole. However, all has not been smooth sailing for the sector, especially the banking industry (read Five Best Performing ETFs (So Far) in 2012).

A series of banking scandals and hedging losses and worries over the euro zone debt crisis continue to affect the investors’ sentiment towards the banking industry. Also, the diminishing growth rate of the U.S GDP (1.5% for 2Q12 down 0.5% form 1Q12 growth rate of 2%) is a clear indication of the slowdown in the economy caused primarily by demand driven factors.

Clearly, the marked slowdown in the economic growth coupled with high unemployment levels have resulted in a deceleration in credit growth in the economy. As a result, it has marred revenue growth for the banks.

Also, while the ultra low rate policy of the Federal Reserve and the third round of quantitative easing will surely give a boost to the economy, it will also cause profit margins of banks to decline, especially for bigger, asset-sensitive banks (read Long Term Treasury ETFs: Ultimate QE3 Play?).

Banks are now faced with a challenge of taking on additional risks on the lending front in order to increase their net-interest margins. However it would be at the expense of having to compromise on their asset quality, a tradeoff which not all banks can afford. Also, the recent monetary policies clearly suggest that the interest rates are bound to remain low for quite some time, therefore the net interest margins could remain under pressure.

Nevertheless, the U.S Banks are well positioned to respond to regulators’ shifts. Higher capital provisioning (with the implementation of Basel 3) will no doubt result in lower Return on Equity (ROE) for most banks, but will also strengthen the cushion to absorb losses thereby preventing bank failures of any kind. Also, the de-leveraging undertaken by banks will surely enhance strength of the balance sheets; however this is bound to happen at the expense of their near term profitability.

However, with the unexpected implementation of QE3, consumption demand is likely to be restored in the economy. This will provide an opportunity for banks to strengthen their top- line revenues in the form of loan growth. Nevertheless, despite all the negativity, the banking industry has shown great resilience, and for investors looking for a basket approach in the industry, we have highlighted a few ETFs that could be attractive investment opportunities.

SPDR S&P Bank ETF (KBE)

It is a product by State Street which tracks the performance of the banking industry. Its portfolio is composed of the all the banking stocks listed in the U.S stock exchanges as represented by the S&P Banks Select Industry Index.

After losing more than 22% in 2011, it has come back strongly in fiscal 2012 returning 20.6% in the first quarter (ending March 2012) itself. The ETF is up by almost 20% this year as on 26^th September 2012. However, global economic pessimism and a series of banking sector hedging losses and scandals had caused the ETF to slump by 8% in the second quarter of fiscal 2012 (see Two ETFs that Have Surged from Their Lows).Since its inception in November of 2005, the ETF has been able to amass $1.68 billion in its asset base. It charges investors a fee of 0.35% annually and pays out 1.87% as yield. Also, the ETF boasts of an average daily volume of more than 2.3 million shares. The ETF holds 40 stocks with 27% allocation in the top 10 holdings.

KBE currently has a Zacks Rank of 3 or ‘Hold’ with a Medium risk outlook.

PowerShares Dynamic Banking ETF (PJB)

Has a portfolio of 30 stocks that are engaged in deposit and lending activities including banks, money centers as well as regional banks. The stocks are selected based on various fundamental factors which discount their share price performance, management quality, acceleration in earnings as well as near term market sentiments measured as market momentum.

PJB allocates 46% of its total assets in the top 10 holdings which include names like J.P. Morgan Chase, U.S. Bancorp, Wells Fargo & Co and BB&T Corporation. The ETF was launched in October of 2006, however it has not been able to capture interest of the investors as indicated by an asset base of just $12.60 million.

Also, it charges a hefty expense ratio of 0.65% and pays out 1.35% as yield. On an average around 2,700 shares of PJB are traded each day. This coupled with a below par asset base has resulted in a high bid-ask spread ratio which would hurt investors by increasing total cost of their investment in PJB (see more in the Zacks ETF Center).

From a performance perspective, PJB has returned around 20% so far this year as on 26^th September 2012. However, like most of the financial sector ETFs, PJB was in turmoil last fiscal where it slumped almost 10% in 2011. PJB currently has a Zacks Rank of 4 or ‘Sell’ with a Low risk outlook.

PowerShares KBW Bank ETF (KBWB)

Launched in November of 2011, PowerShares KBW Bank ETF (KBWB) seeks to track the pre expense price and yield performance of the KBW Bank Index. The index is maintained and weighted by Keefe, Bruyette & Woods, Inc.

The benchmark is modified capitalization weighted adjusted for free float and measures the performance of U.S. listed banks and money centers.

Since its inception, the ETF has amassed $211.39 million in assets, making it a reasonably popular choice for investors (read Are Foreign Financial ETFs Back on Track?). KBWB is a cost-effective choice for investors as it only charges 35 basis points per annum in fees and expenses compared to a category average of 0.58%.

The ETF focuses on large cap mainstream banks as well as regional banks and money centers. The fund currently holds a fairly small portfolio of 24 securities in all and allocates 60.71% of the total assets in its top 10 holdings.

After a brief correction in its prices in the month of June 2012, KBWB is trading at attractive valuations with a PE below 12 and price/book below 0.9. KBWB has posted impressive returns of 22.33% since its inception as of 31st August 2012 (see For Financials, Look to These Top Zacks Ranked ETFs).

KBWB currently has a Zacks Rank of 2 or ‘Buy’ with a Low risk outlook

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SPDR-KBW BANK (KBE): ETF Research Reports

PWRSH-KBW BP (KBWB): ETF Research Reports

PWRSH-DYN BKG (PJB): ETF Research Reports

SPDR-FINL SELS (XLF): ETF Research Reports

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