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.

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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.

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