Blood In The Streets Could Mean Opportunity With Bank ETFs

Down almost 12 percent year-to-date, the Financial Select Sector SPDR XLF is the worst performer among the nine established sector SPDR exchange traded funds this year. XLF is far from the only financial services offender as ETFs tracking the S&P 500's second-largest sector are being plagued by the flattening yield curve and lower oil prices, among other factors.

However, there are some factors to consider. First financial services have a tendency to underperform in down markets. Second, banks are in better shape today than they were in 2008 and 2009. At least U.S. banks. Third, sliding oil prices as a drain on the financial services is problem that might be overstated.

“First, exposure to the energy sector--both direct and indirect--is more than manageable. Below-investment-grade energy bonds are pricing in losses of roughly 30%, which would result in losses of only 2.5% of equity value, or only one quarter's worth of earnings for a bank otherwise achieving a 10% return on tangible common equity. Otherwise, most large U.S. bank balance sheets remain rock-solid, in our view,” said Morningstar in a recent note. 

Adding, to the near-term problems for U.S. bank stocks and ETFs like XLF is that when the sector climbed last year as invetors were betting on the Federal Reserve raising interest rates, the group became expensive on valuation.

Patient investors could be rewarded with bank stocks and ETFs in the form of consistently rising dividends. The financial crisis undid decades' worth of dividend ebullience from big banks in short order, leaving some income investors scorned and doubting the sector's future dividend growth prospects.

As S&P Capital IQ notes, some dividend ETFs still have relatively low weights to the financial services sector because those ETFs rely on dividend increase streaks as part of their weighting methodology, indicating sector ETFs could be the preferred avenues for playing financial services dividend growth.

“Furthermore, though declining long-term interest rates are problematic in the short-term, we expect lower mortgage rates--along with a sizable and aging population of millennials, easing credit standards, and a reasonably healthy employment market—to contribute to an eventual rebound of the housing market. Finally, counterparty risk and notional derivative exposures are at the top of investors’ minds. Here too, we believe fears are overblown. Net exposures to individual asset classes, events, or counterparties are relatively manageable-especially in the case of interest rates which make up a bulk of reported notional exposures,” said Morningstar.

Todd Shriber owns shares of XLF.