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The financial services sector is the third-largest sector allocation in the S&P 500. At a weight of 13.79% (as of Aug. 31), financials trail only technology and healthcare in the benchmark U.S. equity gauge.
Investors often favor financial services stocks and the related exchange traded funds (ETFs) when interest rates are rising, which describes the current market environment. Historically, financial ETFs and stocks are positively correlated to rising Treasury yields, but there are no guarantees financial ETFs will outperform as interest rates rise.
Year-to-date, the Financial Select Sector SPDR (NYSEARCA:XLF), the largest financial ETF by assets, is up just 2%. The S&P 500 is outperforming XLF by a margin of more than 4-to-1. XLF is one of many financial ETFs that weight components by market value, meaning those funds tilt toward the largest financial stocks, but there are other avenues for approaching the sector.
Investors seeing value in this lagging sector may want to consider some of the following financial ETFs, some of which could be boosted as the Federal Reserve continues raising interest rates.
Financial ETFs to Buy: Fidelity MSCI Financials ETF (FNCL)
Expense Ratio: 0.o84% per year, or $8.40 on a $10,000 investment.
There are plenty of plain vanilla financial ETFs on the market, but the Fidelity MSCI Financials ETF (NYSEARCA:FNCL) is the winner when it comes to low fees. Fidelity clients can realize additional costs savings with FNCL because the firm does not charge commissions on its ETFs.
The $1.6 billion FNCL tracks the MSCI USA IMI Financials Index and holds 388, giving this a financial ETF a significantly larger roster than the rival XLF. FNCL features some exposure to smaller financial stocks, but the fund leans toward large- and mega-cap financials, such as JPMorgan Chase (NYSE:JPM) and Bank of America (NYSE:BAC).
FNCL is considered a diverse financial ETF, but that usually means a fund dominated by money center banks, insurance providers and capital market firms. This financial ETF is up about 2% year-to-date and has seen inflows of $381.30 million as investors gravitate toward the least expensive ETFs.
Financial ETFs to Buy: Invesco S&P SmallCap Financials ETF (PSCF)
Expense Ratio: 0.29%
The Invesco S&P SmallCap Financials ETF (NASDAQ:PSCF) is the small-cap answer to the aforementioned XLF. Like its large-cap counterparts, PSCF is trailing broad market benchmarks. While PSCF has been a better bet this year (up 9.6%) than the S&P 500, this financial ETF is trailing the S&P SmallCap 600 Index.
Real estate is its own sector now, but real estate stocks still reside in PSCF to the tune of over 31%, acting as something of headwind because that sector is inversely correlated to rising interest rates. Still, PSCF offers more-than-adequate exposure to the rising rates and surging small-cap themes. Plus, this financial ETF allocates over 36% of its weight to value stocks, a potent combination when paired with small-caps.
This financial ETF holds 134 stocks with an average market value of $1.96 billion, putting it at the higher end of small-cap territory. PSCF is higher by about 2% over the past month as small caps extend their lead over larger equities.
Financial ETFs to Buy: ETF Industry Exposure and Financial Services ETF (TETF)
Expense Ratio: 0.64%
There are financial ETFs and then there are financial ETFs with direct exposure to the booming ETF industry. The ETF Industry Exposure and Financial Services ETF (NYSEARCA:TETF) fund is the king of that group.
TETF’s 43 holdings “range from fund sponsors, to index & data companies, trading & custody platforms, liquidity providers, and exchanges,” according to the issuer.
TETF does a good job of balancing ETF issuers along with companies engaged in other parts of the ETF ecosystem. Just nine of the fund’s top 20 holdings are directly involved in issuing and sponsoring ETFs. Simply put, TETF is a play on a long-term ETF industry growth prospects, and those prospects are rosy.
Earlier this year, BlackRock Inc. (NYSE:BLK), the world’s largest ETF issuer and a TETF component, said ETF assets under management could hit $25 trillion over the next five years. TETF reflects those expectations as it is outpacing XLF by about 350 basis points over the past year.
Financial ETFs to Buy: SPDR S&P Regional Banking ETF (KRE)
Expense Ratio: 0.35%s
Investors looking for financial ETFs that have more leverage to rising interest rates than diversified sector funds can consider regional bank ETFs, such as the SPDR S&P Regional Banking ETF (NYSEARCA:KRE).
KRE, which is an equal-weight fund, is proving its rising rates merit this year with a gain of 8%, which is easily better than diversified financial ETFs. Rising interest rates typically boost net interest margins for regional banks, explaining why this segment of the financial services sector often displays positive correlations to rising Treasury yields.
The downside is that market participants have a tendency to punish regional bank stocks and funds like KRE following Federal Reserve meetings where expected rate hikes do not materialize. Over the past several years, a fair percentage of KRE’s drawdowns are attributable to the Fed delaying rate hikes.
Financial ETFs to Buy: SPDR S&P Insurance ETF (KIE)
Expense Ratio: 0.35%
Insurance stocks are another group that, historically speaking, performs well in rising interest rate environments. The SPDR S&P Insurance ETF (NYSEARCA:KIE) is trailing the broader market this year, but the insurance fund is beating diversified financial ETFs and resides near all-time highs.
KIE holds 50 stocks and uses the equal-weight methodology, which potentially reduces single stock risk. The weighted average market value of KIE components is $17.57 billion, putting the fund at the lower end of the large-cap space.
Over the past three years, KIE has been less volatile than broad-based financial ETFs and the insurance fund’s price-to-book and price-to-earnings ratios imply attractive valuations relative to the S&P 500.
Financial ETFs to Buy: First Trust NASDAQ ABA Community Bank Index Fund (QABA)
Expense Ratio: 0.6%
Among financial ETFs, the First Trust NASDAQ ABA Community Bank Index Fund (NASDAQ:QABA) often goes overlooked, though the fund is not particularly small or young. This financial ETF is over nine years old and has nearly $404 million in assets under management.
QABA is a financial ETF for investors looking to capitalize on themes of small-cap financials that are regional banks with positive leverage to rising interest rates. The fund’s 169 holdings have a median market value of $931 million, confirming QABA’s small-cap status.
An important detail with regional bank funds is where the funds’ regional exposure is sourced … meaning investors want a financial ETF with exposure to vibrant local economies. QABA meets that requirement with a combined weight of over 21% to California and Texas, the two largest state economies in the U.S.
Financial ETFs to Buy: Invesco Global Listed Private Equity ETF (PSP)
Expense Ratio: 2.03%
The private equity universe is typically reserved for pension plans, college endowments and other institutional investors as well as ultra-high-net-worth individuals. Significant barriers to entry in the form of massive investment and net worth requirements usually keep ordinary investors out of the private equity arena, but some financial ETFs make this universe more accessible.
Enter the Invesco Global Listed Private Equity ETF (NYSEARCA:PSP), which tracks the Red Rocks Global Listed Private Equity Index, one of the most widely followed gauges of publicly traded private equity companies.
PSP’s benchmark “includes securities, ADRs and GDRs of 40 to 75 private equity companies, including business development companies (BDCs), master limited partnerships (MLPs) and other vehicles whose principal business is to invest in, lend capital to or provide services to privately held companies (collectively, listed private equity companies),” according to Invesco.
Relative to traditional financial ETFs, PSP is pricey with an annual fee of 2.03%. Some of that sting is muted in the form of a 12-month distribution rate of 9.9%, indicating PSP is a unique income idea for risk-tolerant, tactical investors. However, PSP’s roster is richly valued compared to those of traditional financial ETFs.
As of this writing, Todd Shriber owned shares of XLF.