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Financials: Next Domino To Fall

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article features Clayton Fresk, CFA, portfolio management analyst at Georgia-based Stadion Money Management.

It has been a rather eventful past few months in the market. After a tumultuous third quarter and an optimistic fourth quarter of 2015, performance so far in 2016 has been brutal.

As of the close on Feb. 11, the S&P 500 was down some 10% for the year. Additionally, interest rates have plummeted, with the 10-year Treasury yield falling more than 60 basis points in 2016 alone. This combination of risk-off trading and a lower-rate environment has proved a strong head wind to the financial sector.

Financials is now the third GICS sector to enter a bear market (following energy and materials). There are different ETF offerings in the financial space, so let’s break down some industry exposure, and offer some alternatives.

Each financial ETF has a slightly different index and/or methodology. Here is a table with performance from 7/22/15 forward:

Ticker

Fund

AUM ($M)

Performance: 7/22/15 - 2/11/16

XLF

Financial Select Sector SPDR Fund

14,893.65

-22.26%

VFH

Vanguard Financials ETF

3,016.21

-21.00%

IYF

iShares US Financials ETF

1,102.09

-20.45%

FXO

First Trust Financial AlphaDEX Fund

773.05

-18.97%

FNCL

Fidelity MSCI Financials Index ETF

200.25

-20.91%

PSCF

PowerShares S&P SmallCap Financials Portfolio

153.27

-17.52%

RYF

Guggenheim S&P 500 Equal Weight Financials ETF

134.69

-20.27%

RWW

Oppenheimer Financials Sector Revenue ETF

20.34

-23.79%

As you can see, performance across the funds has been weak, with all but FXO and PSCF seeing a greater than 20% drawdown over the period. It’s also interesting to note that smaller-cap names have delivered outperformance compared with their larger-cap counterparts. This is evidenced in the relative performance of PSCF, which focuses on the small-cap exposure, and of FXO, which has a greater allocation to the midcap financial names relative to the broader universe.

Industry Exposure

Within the financial space, we have also seen some divergence in the underlying industry exposure. Using XLF as an example, here is a breakdown of the underlying industry group exposure and corresponding performance over the same period:

As you can see, there is a decent amount of dispersion in the underlying returns. Those industries that face head winds from a lower rate environment—such as banks and capital markets—have fared much worse over the period. Conversely, industries that have a higher negative correlation to rate—namely, REITs—have stronger relative performance.

This industry exposure is another differential between those ETFs. Highlighting the same two ETFs as previously—FXO and PSCF—here is a weighting and performance comparison versus the XLF breakdown:

This table tells us a few things. First, that PSCF has a higher overall bank exposure, and its bank exposure has performed admirably versus XLF (-20% versus -28%). Additionally, PSCF also has a much higher weighting to REITs: nearly 32% versus 16% in XLF. Both of these factors have contributed to the recent relative outperformance.

It also tells us that FXO has benefited from both a lower bank exposure despite slightly lower performance compared with XLF. Additionally, because of the differing universe and methodology, FXO has the benefit of including “other” exposure not categorized as financials in the GICS methodology, the bulk of which is in software and services (e.g., payment systems). This exposure has performed strongly relative to the broader financial universe.

Preferreds

While not a pure financial play by any means, preferred ETFs are predominantly populated by issuers in the financial industry; namely, banks.

As such, they have some correlation to the financial sector, which has been evidenced as of late by a rather rapid sell-off in various preferred ETFs. Here is a table with YTD performance of various preferred stock ETFs:

Ticker

Fund

AUM ($M)

Performance: YTD

Performance: 2016

PFF

iShares US Preferred Stock ETF

13,484.80

-6.24%

4.27%

PGX

PowerShares Preferred Portfolio

3,556.35

-5.43%

7.92%

PGF

PowerShares Financial Preferred Portfolio

1,695.01

-6.08%

9.21%

FPE

First Trust Preferred Securities and Income ETF

666.80

-5.20%

6.12%

VRP

PowerShares Variable Rate Preferred Portfolio

516.52

-6.95%

3.36%

PSK

SPDR Wells Fargo Preferred Stock ETF

386.82

-4.42%

7.74%

PFXF

Market Vectors Preferred Securities ex Financials ETF

233.53

-2.90%

-1.50%

SPFF

Global X SuperIncome Preferred ETF

195.91

-7.20%

-2.96%

Because of their hybrid equity and fixed-income characteristics, preferreds have not experienced the same magnitude of drawdown as compared with broad financials—as a point of reference, XLF is down -17.5% on a YTD basis.

To isolate the “rate effect,” here is a chart of the option-adjusted spread (OAS) of the BAML Core Plus Fixed Rate Preferred Securities Index, which is the benchmark for PGX:

As you can see, preferred spreads held relatively steady during the post-July 22 period, where performance heading into 2016 was very strong, outside of a small blip in spreads in December. However, so far this year, it has been a different story. The move has wiped out most, if not all, of the 2015 returns in a mere six weeks (see table above).

The financial effect is magnified by looking at the relative performance of PFXF, which excludes financial securities. It is down only about 3% this year. Conversely, however, it also did not receive the benefit of financials in 2015, as can be seen above.

What This Means To You

It has been a rough market over the latter half of 2015 and thus far in 2016, leading financials to be the third GICS sector to enter a bear market. Interest rates could bounce off the rapid decline we have seen this year, which could provide some tailwind to the sector. However at this point, financials are having a rough go, and relief may not be in sight.

The above constitutes the personal, professional opinion of Clayton Fresk, CFA, and does not necessarily reflect the views of Stadion Money Management LLC. At the time this article was written, Stadion held long positions in PGF and PFF. References to specific securities or market indexes are not intended as specific investment advice. Founded in 1993, Stadion Money Management is a privately owned money management firm based near Athens, Georgia. Via its unique approach and suite of nontraditional strategies with a defensive bias, Stadion seeks to help investors—through advisors or retirement plans—protect and grow their “serious money.” Contact Stadion at 800-222-7636 or www.stadionmoney.com.



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