Financials ETFs In Flux

A brief steepening of the yield curve two weeks ago was enough to send U.S. financial stocks sharply higher, leading the S&P 500 in gains at times, and fueling talk that perhaps the beleaguered sector is finally going to break out.

In the past week alone, investors poured almost $600 million into the Financial Select Sector SPDR Fund (XLF) as 10-year Treasury yields inched ever so slightly higher. That’s noteworthy, because the prevailing flows trend for XLF this year has been negative, with the $22 billion fund now sitting with $3.5 billion in net redemptions year to date.

Other financials ETFs, particularly those focused on banks, have also struggled to find new assets despite what’s been a relatively good performance, all things considered.

Biggest Financials ETFs Outflows YTD

Measured by the performance of XLF, financials have lagged the S&P 500 throughout the year (as measured by the SPDR S&P 500 ETF Trust (SPY)). But that underperformance isn’t as bad as some had expected given the interest rate environment.

The yield on the 10-year Treasury is down about 1% this year. The yield curve has been very flat—and at times inverted—and the Federal Reserve has already lowered rates twice in 2019. The shape of the curve is very important, particularly for smaller banks, because it impacts their ability to turn a profit. When the curve is this flat, banks’ net profit margins are squeezed.

Lower rates have helped bring mortgage rates down, and demand for loan refinancing and new mortgages has increased in the past year.

Unless mortgage generation is part of a diversified business line, there’s little benefit to smaller banks focused on retail lending, where lower rates may allow for some growth in volume as people take on loans, but margins will shrink.

Treasury Yield Curve As Of Oct. 10, 2019

Source: U.S. Dept. of Treasury

There is also the overhanging trade dispute with China, which has impacted all sectors of the market.

Bank ETFs Returns & Assets Fall

Regional banks typically don’t have international exposure, so in theory they should withstand a trade war better than bigger banks and financial institutions. But they are very rate sensitive, because they don’t typically have diversified sources of income.

In the ETF space, investors have largely shunned regional bank ETFs so far this year, some of which have lost about half their total assets in 2019.

The SPDR S&P Regional Banking ETF (KRE), the biggest regional banking and fourth largest financials ETF, with $1.6 billion in assets, has lost $1.5 billion in net redemptions this year. The SPDR S&P Bank ETF (KBE) has bled $1.3 billion. The iShares U.S. Regional Banks ETF (IAT) is down about $250 million. The list goes on, even though they are all delivering positive—albeit underperforming—results.

Mortgage, Insurance ETFs Gain

Beating the outflows trend in financials this year, however, are ETFs that focus exclusively on insurance companies and mortgages.

Net asset creations are very modest year to date, but they aren’t negative. It’s been a strong year for insurance companies, and ETFs focused on these stocks, such as the SPDR S&P Insurance ETF (KIE) and the Invesco KBW Property & Casualty Insurance ETF (KBWP), are up sharply.

Mortgage & Insurance ETFs Top Gainers YTD

For mortgage generators, loan volume is expected to increase as rates drop. A 30-year fixed rate mortgage now averages 3.5%, down from 4.9% a year ago, MarketWatch reported. According to the report, while lower rates have boosted demand for loan refinancing—up some 160% year on year—more than for new mortgages, the numbers are trending higher, data from Mortgage Bankers Association shows.

YTD Performance Relative To XLF

Charts courtesy of StockCharts.com

With earnings season upon us, a lot of attention will fall on many of these companies, as the market looks for a catalyst to push financials (XLF) back toward the sector’s 2018 highs—a resistance level the market has yet to breach this year.

Contact Cinthia Murphy at [email protected]