Banks Ace Fed Stress Test; These ETFs Benefit

Todd Rosenbluth is director of ETF and mutual fund research at CFRA.

After another successful year passing the Federal Reserve’s stress tests, many large-cap financial institutions received the green light yesterday to return capital to shareholders through dividends and buybacks.

Shareholders of Bank of America, Citigroup, JPMorgan Chase, Morgan Stanley and Wells Fargo—both direct and through funds—should expect to see such cash deployment in the second half of 2017.

Following the recent financial crisis, many banks and brokerage firms cut their dividends to preserve capital, ending a string of providing consistently high income streams to their investors.

Growing Income Generation

Whereas insurance companies—such as Cincinnati Financial and Old Republic International—are constituents in ETFs that focus on companies with 20-plus years of dividend hikes, including the ProShares S&P Dividend Aristocrats ETF (NOBL) and the SPDR S&P Dividend ETF (SDY), large banks and brokers are not well-represented in these diversified ETFs.

However, with the latest hikes, CFRA thinks they have begun to rebuild their reputation of growing income generation.

For example, some of the biggest changes occurred at Citi and Bank of America, which doubled and boosted their dividend 60%, respectively. J.P. Morgan and Morgan Stanley also had double-digit percentage increases in their dividends, while Wells Fargo raised its cash payout only modestly.

Capital Return Plans of Select Large-Cap Financials

Source: Company press releases

CFRA has a positive fundamental outlook on the diversified bank and the investment banking and brokerage subindustries. Ken Leon, an equity analyst for CFRA, believes many of the large-caps in these industries will benefit from recent and future increases in the fed funds rate.

The dividend moves should help improve the recently below-average 1.7% dividend yield for the S&P 500 financial sector. Not surprisingly, ETFs that focus on companies with higher yields, such as the iShares Core High Dividend ETF (HDV), have limited exposure to financials. Indeed, HDV had a recent 1% stake in the sector.

Average Dividend Yield of S&P 500’s Sectors

Source: S&P Global, June 23, 2017

Naturally, ETF investors can gain direct exposure to these large-cap financials through the Financial Select Sector SPDR Fund (XLF), the largest such sector ETFs, as well as the Vanguard Financials ETF (VFH), the PowerShares KBWB Bank Portfolio (KBWB) and the SPDR S&P Bank ETF (KBE).

Dividend Funds Benefit As Well

There are also some dividend funds among the winners via the increased return of cash to shareholders. The iShares Core Dividend Growth ETF (DGRO) had a 14% weighting in financials, including many that raised their dividends this week. In addition to top-10 holdings J.P. Morgan and Wells Fargo, U.S. Bancorp and American Express are in that 14%, and similarly hiked their dividends; technology is the largest sector for this ETF.

Meanwhile, the Fidelity Dividend ETF for Rising Rates (FDRR) holds Bank of America, Citi, J.P. Morgan and Wells Fargo within its 9% stake in the financial sector. As its name suggests, this index-based ETF holds dividend payers that have historically performed well during periods of rising bond yields. Information technology and health care stocks are also well-represented.

Though FDRR and DGRO are less than three years old, CFRA has a ranking on them as we leverage our holdings-based analysis. In addition to a review of the ETF’s costs and trading patterns, we assess the valuation and risk attributes of the ETF’s portfolio.

Among active mutual funds, TCW Relative Value Dividend Appreciation recently had a 21% stake in financials, with Citi and J.P. Morgan among its top-10 positions.

More Buybacks Coming

While owners of these funds are benefiting in the near term from the dividend increases, many of these same companies announced share repurchase programs that will be deployed and help earnings over the more intermediate term. For example, J.P. Morgan and Citi expect to repurchase $19 billion and $16 billion of their own stock, respectively; American Express announced its own $4.4 billion program.

The PowerShares Buyback Achievers Portfolio (PKW) holds stocks of companies that have repurchased 5% or more their shares in the last 12 months. The ETF recently had a 24% stake in financials, including American Express and Goldman Sachs. Goldman did not announce a new buyback program last night, as peers did, but its CEO said it was well-positioned to return capital to shareholders following the Fed’s approval of its capital return plan.

CFRA’s Leon views Goldman Sachs as undervalued, and sees revenue and earnings being aided by improving capital markets.

While direct owners of these financials are likely pleased with the continued deployment of capital, signifying industry health, CFRA thinks that some—but not all—ETF shareholders are also impacted.

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.