Here Are the Hottest Financial-Sector ETFs

TheStreet.com

NEW YORK ( TheStreet ) -- Most exchange-traded funds that track the financial sector have rallied lately, but the gains have been particularly strong for ETFs that specialize in insurance and regional banks.

This year SPDR S&P Regional Banking returned 28.0%, and SPDR S&P Insurance gained 28.5%, according to Morningstar.

In comparison, Vanguard Financials , which holds a broad mix of financial stocks, gained 21.6%, and the S&P 500 returned 19.7%.

The outlook for the hottest financial ETFs remains positive because regional banks and insurers tend to perform well when interest rates are climbing.

Insurance companies take in premiums and invest the cash in portfolios of bonds. When yields increase, the income from bond portfolios also climbs. If we are entering an era of higher interest rates -- as most economists expect -- then it is likely that insurers will report stronger returns on equity in coming years.

This year insurance companies have gotten an additional boost from rising premiums. The gains appear to signal the beginning of an upward cycle. The industry tends to go through premium cycles that last for several years.

During some periods, insurers become more aggressive, slashing premiums to gain more market share. Eventually premiums become too skimpy. With profit margins unacceptably low, the industry begins raising premiums, and a new cycle starts. In recent years, premium cuts hurt profits. Now companies are raising premiums as the industry strives to fatten bottom lines -- and avoid destructive price cutting.

The biggest insurance ETFs are SPDR S&P Insurance, with $354 million in assets, and iShares U.S. Insurance , with $149 million. The two funds have delivered similar returns recently. During the past 12 months, the SPDR ETF returned 33.5%, while the iShares competitor returned 34.8%.

When rates rise, banks can charge customers more for loans. That helps institutions of all sizes. But regional and community banks tend to receive a special lift from climbing rates.

The smaller banks tend to be simple operations that focus on making loans to individuals and small businesses. Besides making loans, money center banks have a variety of complex businesses -- such as investment banking and derivatives trading -- that don't necessarily improve when rates rise.

During the financial crisis, the regional banks performed better than the money center giants, which were held down by losses in their derivatives businesses.

In 2008, iShares U.S. Regional Banks lost 33.6%, compared to a decline of 54.7% for Financial Select Sector SPDR , which is dominated by money center institutions.

Although the regional banks have already recorded huge gains since the financial crisis, it seems likely that they can continue performing well. Pressured by regulators, most banks have been tightening their lending standards. That will limit defaults, helping to protect profits.

To hold regional banks, consider SPDR S&P Regional Banking, with $2 billion in assets, or iShares U.S. Regional Banks , with $510 million.

An intriguing way to own a dose of insurers and banks is FAM Value , an actively managed mutual fund that has one-third of its assets in financials.

The portfolio managers seek unloved companies with strong cash flows and solid balance sheets. Lately they have been finding insurance companies that sell for less than their historical values.

One holding is Markel , a property/casualty insurer. The company specializes in a range of niches, providing coverage for ambulances, ocean cargo, and day-care centers.

FAM portfolio manager John Fox says that Markel has typically traded for between 1.1 and 1.5 times book value.

At the moment the stock is near the bottom of the range. The company recently made an acquisition that should eventually boost the stock, says Fox. "This will increase the earnings power and the returns on equity," he says.

Another holding is White Mountains Insurance . The stock sells for a bit less than book value. The company provides specialty insurance and reinsurance, which is coverage for other insurers.

At the time of publication, Luxenberg held no positions in securities mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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