Big Financial ETF Tagged With 'Speculative' Rating

Low interest rates and a sluggish economy are among the factors punishing the financial services sector and the related exchange-traded funds this year.

What Happened: The Financial Select Sector SPDR XLF, the largest ETF dedicated to this sector, is lower by 21.05% year to date. That's not the worst performance among sector ETFs, but it's still bad.

Historically low interest rates and rising loan loss reserves are hindering bank stocks, prompting some analysts to proceed cautiously with XLF. In a recent note. AltaVista Research put a “Speculative” rating on XLF.

To put that rating into context, AltaVista covers all 11 of the sector SPDR ETFs, but XLF is the only one sporting a “Speculative” rating.

Why It's Important: An ETF with a “Speculative” mark from AltaVista is considered “deeply undervalued but risky.”

“A rating of SPECULATIVE is assigned to ETFs with ALTAR Scores in the top quintile (the top 20%) of their category, indicating exceptional appreciation potential,” according to the research firm. “However, often these are narrowly-focused funds or in industries with structural issues, which may also make them very risk.”

Adding to XLF's woes, the Federal Reserve is still restricting distributions of shareholder rewards, removing a potential motivating factor to own these stocks. Last week, the central bank said it will limit bank dividends in the fourth quarter while saying buybacks are off the table.

XLF yields 2.63%, which is higher than what investors get on the S&P 500, but with near-term dividend growth prospects limited, XLF may not be the most appealing income idea.

What's Next: Earnings growth could help XLF components right the ship, but there are no guarantees of that materializing anytime soon.

“The decline in profitability this year is much less severe than during the Financial Crisis, and estimates have stabilized,” said AltaVista. “Eventually we think Financials can return to the ~11% ROE achieved in 2018-19, but the sector's very depressed P/BV multiple implies otherwise. Thus our Speculative rating reflects the significant risks that accompany the sector's large potential upside in recovery. Sell-side analysts remain relatively bearish on Financials, though sentiment has been improving.”

One way XLF holdings can steer earnings in the right direction is if the economy improves and the banks can convert cash set aside for sour loans back into profits.

Disclosure: The author owns shares of XLF.