Banking ETFs: Why This Time May Be Different
Outperformance in a rising rate environment would be a change from the past.
In 2017, certain financial services ETFs have received large inflows due to what CFRA sees as increased confidence that macroeconomic and political developments will drive these securities higher. Yet if this were to occur, during a rising interest environment, the outperformance would be different than what occurred in prior rising rate prior periods.
According to Sam Stovall, chief investment strategist at CFRA, during rising rate periods since 1970, the S&P 500 financials sector has traditionally underperformed the S&P 500. He cited the -0.70 correlation between federal funds rate and the yield curve (10-year yield minus the fed funds rate), meaning that when short-term rates rose, the difference between long and short rates fell as inflations fears lessened. This time, however, financial stocks have soared.
Stovall thinks the reasons may be twofold. First, the financial sector is responding to the new president’s pledge to reduce onerous regulatory pressures on the sector. Second, the Fed’s rate-tightening efforts are designed not to “restrain,” but to “recalibrate” the relationship between rates and inflation.
Yield Curve Seen Steepening
Historically, the fed funds rate has averaged about 1.50 percentage points above the year-over-year rise in inflation. Today this relationship would imply that the fed funds rate should hover near 3.8%, not the current sub-1.0% area.
Therefore, Stovall thinks investors likely believe that because of a strengthening economy, the yield curve will steepen, which would ultimately benefit the profit margins of those companies that “borrow short” and “lend long.”
The diversified bank subindustry and regional bank subindustry outperformed the S&P 1500 Index in 2016, climbing 19% and 32%, respectively. Yet CFRA has stars rankings on 40 diversified and regional banks, with strong buys (5 stars) or buy (4 stars) on 14 of them. Bank of America, J.P. Morgan, SunTrust Banks and Signature Bank are some examples.
Why Diversified Banks Can Benefit
“Diversified banks can be big a beneficiary of the above developments and a strengthening economy,”
explained Nick Kalivas, senior equity product strategist at PowerShares. “Regional banks already had a strong run, and there is a perception diversified banks are being held back because of the regulatory challenges.”
In ranking approximately 960 equity ETFs, CFRA combines holdings-level analysis with ETF-level relative attributes. An ETF is reviewed based on the valuation and risk considerations of the holdings as well as its expense ratio and bid/ask spread.
The PowerShares KBW Bank Portfolio (KBWB), a financial ETF with $979 million in assets, pulled in $311 million in new money year-to-date through Feb. 17, according to data on ETF.com. At the end of January, assets were primarily split between diversified banks (42% of assets) and regional banks (41%), with smaller stakes in asset management and custody banks (11%), and consumer finance companies (4%). Bank of America, J.P. Morgan and SunTrust were among the fund’s top-10 holdings. KBWB has a 0.35% expense ratio.
Meanwhile, the Financial Select Sector SPDR (XLF), a $25 billion ETF, expanded its asset base by $1.5 billion year-to-date. While banks (45% of assets) was the largest industry, predominantly through large-cap diversified banks, the capital markets, diversified financial services and insurance industries each had double-digit percentages of assets. XLF has a 0.14% net expense ratio.
Regional Banks Favored In Multi-Cap Approach
A similar multi-industry offering, the Vanguard Financials Index Fund (VFH) pulled in $475 million in new money, expanding its assets to $5.6 billion. Here, too, bank exposure (46%) is larger than the other industries, though regional banks are more heavily weighted due to the multi-cap nature of the portfolio. For example, midcap Signature Bank is a VFH holding, but the bank is not inside XLF. Insurance and capital markets industries are each 10%-plus of the ETF’s assets. VFH has a 0.10% expense ratio.
In contrast, the asset base has shrunk in 2017 due to a fellow SSGA offering, the SPDR S&P Bank ETF (KBE). The $3.3 billion fund has had $67 million in assets in net outflows in 2017. Unlike KBWB, XLF or VFH, KBE is an equally weighted portfolio.
Yet similar to KBWB, KBE has a 0.35% expense ratio and has 80%-plus of its assets in banks. KBE has more than 70% in regional banks, and a much smaller stake in diversified banks, making it quite different than the PowerShares product. Not surprisingly to us, KBWB underperformed KBE in 2016, but has done better year-to-date through Feb. 17.
At the time of writing, neither the author nor his firm held any of the securities mentioned. Todd Rosenbluth is director of ETF and mutual fund research at CFRA, an independent research firm that acquired S&P Global Market Intelligence's equity and fund business in October 2016. He can be reached at [email protected]. Follow him at @ToddCFRA
