If you bought the Financial Select Sector SPDR ETF (ARCA:XLF) when it was created in December 1998, 44% of your investment has been lost. Seventy-eight percent of your investment is gone if you purchased the ProShares UltraShort Financials ETF (ARCA:SKF), a fund that attempts to track twice the inverse daily performance of the Dow Jones U.S. Financials Index, when it launched in February of 2007. Timing is everything for long and short financial exchange-traded funds (ETFs) that have been a lose-lose scenario for early investors.

Investopedia Markets: Explore the best one-stop source for financial news, quotes and insights.

Bank on Problems

Banks have been the driver of financial ETFs. The SPDR KBW Bank ETF (ARCA:KBE), which tracks the common shares of national money centers and regional banks, is down 62% since inception in November 2005. With banks trying to put out one fire after the next over the last five years or so, financial ETFs have performed so very poorly. Citigroup Inc. (NYSE:C), a major component of these financial ETFs, was the original harbinger of problems. In the mid-2000s, even though the share price was appreciating, it became increasingly clear that the financial supermarket model Citigroup pioneered was causing inefficiencies, rather than synergies. It was the original too-big-to-fail bank. (For related reading, check out How Do Banks Determine Risk?)

Citigroup's decline precipitated the October 2007 broad market top when big problems began to take hold. By the spring of 2008, the housing market had completely fallen apart and Bear Stearns collapsed. A few months later, Lehman Brothers failed and the rest is history. Before the financial crisis, financials were the largest sector of the market. Now, energy, technology, and utilities all comprise a greater percentage.

Now What?
Considering the fact that almost all financial ETFs are down sharply since inception, is there value to be found in these funds? In regards to the XLF, even if an investor timed the March 2009 bottom and bought financials, the return has been a modest 23% since then. That's about half the S&P's gain over the same period of time - not much to write home about. It doesn't help that the yield from the XLF is a paltry 1.7%, about 42% of what can be earned from the Utilities SPDR ETF (ARCA:XLU). One of the first moves that big banks took to secure balance sheets during the financial crisis was eliminating dividend distributions to retain cash. When big U.S. banks were forced to accept capital infusions from the government, regulators enforced strict dividend rules. On a positive note, expect to see payout ratios of banks holding substantial cash reserves increase in 2012. That should help the performance of long financial ETFs a bit.

It's interesting to note that both bullish and bearish sentiment on financials is very strong. That fact is evidenced by an upsurge in volume. The XLF is commonly the second-most traded ETF, and short interest volume is currently elevated as well. The increase in volatility of the financial sector is due in large part to these diametrically opposed opinions on where financials are headed.

There are very good reasons to like financials at this point, valuation being the primary one. Many major U.S. banks are trading at a discount to both book value and cash. It stands to reason that the market cap of these banks would increase to reflect what's on the balance sheet. Of course, there are just as many, if not more, reasons to dislike financials. Upside down valuations suggest overhang from mortgage-backed securities litigation is enough to wipe out the capital positions of these banks, rending valuation moot. Also, interest rates are near all-time lows, making it difficult for core lending businesses to make money. Needless to say, financials appear to be a very risky play, in either direction. (For more, read Analyzing A Bank's Financial Statements.)

The Bottom Line
History shows that using financial ETFs as a long-term investing strategy isn't wise. The XLF has outperformed the S&P 500 over the past month by a small margin, and almost all of the major banks have beat third quarter earnings expectations, despite a very difficult trading environment. It's always possible to make money using either a long or short position, if you can pick the right side of the trade. Obviously, timing is of the utmost importance when using these funds. Volatility and a high degree of headline risk seem to be the lone certainties right now when it comes to financial ETFs.

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

At the time of writing, Matt Cavallaro did not own shares in any of the companies mentioned in this article.

Related Articles
  1. Technical Indicators

    Explaining Autocorrelation

    Autocorrelation is the measure of an internal correlation with a given time series.
  2. Term

    Public Goods & Free Riders

    A public good is an item whose consumption is determined by society, not individual consumers.
  3. Stock Analysis

    3 Resilient Oil Stocks for a Down Market

    Stuck on oil? Take a look at these six stocks—three that present risk vs. three that offer some resiliency.
  4. Economics

    Keep an Eye on These Emerging Economies

    Emerging markets have been hammered lately, but these three countries (and their large and young populations) are worth monitoring.
  5. Stock Analysis

    Is Pepsi (PEP) Still a Safe Bet?

    PepsiCo has long been known as one of the most resilient stocks throughout the broader market. Is this still the case today?
  6. Investing

    The ABCs of Bond ETF Distributions

    How do bond exchange traded fund (ETF) distributions work? It’s a question I get a lot. First, let’s explain what we mean by distributions.
  7. Investing Basics

    Top Tips for Diversifying with Exotic Currencies

    Is there an opportunity in exotic currencies right now, or are you safer sticking to the major ones?
  8. Mutual Funds & ETFs

    The 3 Biggest Mutual Fund Companies in the US

    Compare and contrast the rise of America's big three institutional asset managers: BlackRock Funds, The Vanguard Group and State Street Global Advisors.
  9. Stock Analysis

    3 Stocks that Are Top Bets for Retirement

    These three stocks are resilient, fundamentally sound and also pay generous dividends.
  10. Professionals

    5 Top-Rated Funds for Your Retirement Portfolio

    Mutual funds are a good choice for emotional investors. Here are five popular funds to consider.
  1. Can mutual funds invest in IPOs?

    Mutual funds can invest in initial public offerings (IPOS). However, most mutual funds have bylaws that prevent them from ... Read Full Answer >>
  2. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  3. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  4. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  5. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  6. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!