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Tickers in this Article: FXO, IAI, IAT, IPF, KBWB, KBWR, KIE, PSP, VFH, XLF
The financial sector at one time seemed like it could do no wrong. Revenue and earnings seemed to go up every year and the sector seemed like the most solid investment around. The financial crisis of 2008 showed that this sector wasn’t immune to financial woes, and investors are still leery of investing too heavily, even though many of these companies have skyrocketed off 2008 and 2009 lows. ETFs offer a way to gain a diversified portfolio of financial sector stocks, letting you pick the type of global or domestic exposure you want and the types of financial companies you want to be primarily focused in .

What’s the Appeal?

Most investors think of the financial sector as big banks, but there are many other sub-industries that offer great diversification benefits.

Other companies in the financial sector include asset management, credit services, insurance brokers, accident, health and life insurance, mortgage investments, REITs, property management, investment brokers, real estate developers and regional or foreign banks .

The main appeal of a diversified financial portfolio is the lucrative potential return. Financials are also some of the largest, most recognized and well-established companies available. In terms of overall market capitalization, the financial sector trails behind only consumer goods and basic materials.

The primary disadvantage of the financial sector is that you don’t always know what you are buying. Financial markets have become increasingly complex, which means making sense of the accounting and potential liabilities in some of these companies is near impossible. This doesn’t mean investors should avoid financials, it just means–as with any investment–don’t invest in only one company and also trust the price action of a stock or ETF over what company CEOs are saying. Price usually indicates there is trouble before the press announces it .

Interest Rates Matter

Higher interest rates should help bank profits and in return help drive profits for the financial sector. Traditionally, banks have made money on the differential between what they pay depositors and what they charge borrowers. But with interest at or near all time lows, this squeezes that margin and restrains profits. When interest rates rise, the margin banks make can widen, which means larger profits.

While in theory this should occur, rising interest rates tax borrowers, especially those who are just barely able to make their mortgage or loan payments. Rising interest rates could put upward pressure on delinquency and default rates, which in turn hurts banks. Also, if banks have purchased large amounts of low-yielding assets, such as bonds, during a period of sustained low rates, as interest rates rise the price of these assets fall, which also hurts profits .

On the flip side, higher interest rates are generally bad for the price of REITs, although this inverse correlation is far from perfect. With a high-yielding REIT, even if the price declines due to rising rates the high yield you receive will insulate you from some of the initial depreciation.

Watch Your Mega Bank Weight

Some ETFs are very heavily weighted in a handful of large banks, such as Bank of America (BAC), JP Morgan (JPM), Citigroup (C) and Wells Fargo (WFC) to name a few. Some exposure to these major banks is likely good for most investors, since the banks are significant players in the financial sector, but also investing in other financial ETFs that use different allocation methods not focused on major banks will provide a more diverse group of portfolio holdings.

The Financial Select Sector SPDR  is the most popular ETF in the sector according to average volume. It has 82 holdings, but about 50% of the ETF’s assets are in the top 10 holdings, which include the mega banks .

The following table shows four additional financial ETFs. The first two are weighted more heavily in mega banks, while the next two have a more diverse allocation (data as of 8/28/2013).

Ticker SymbolETF NameLargest Allocation
VFHFinancials ETFWells Fargo & Co. (6.4%)
KBWBKBW Bank PortfolioCitigroup (9.0%)
FXOFinancials AlphaDEX FundMBIA Inc (1.4%)
KRESPDR S&P Regional Banking ETFSVB Financial Group (1.8%)

Going Beyond Banks

There are a number of prominent sub-sectors in financials that allow you to fine-tune your focus in particular areas of interest. iShares US Broker-Dealers ETF  has roughly 22 holdings and is largely weighted in broker-dealer companies such as Goldman Sachs (GS), Charles Schwab (SCHW) and CME group (CME). SPDR S&P Insurance ETF  has approximately 48 insurance company holdings with each stock making up about 2% of the portfolio.

Another option is the Listed Private Equity ETF , comprised of business development companies and other financial institutions that invest and lend primarily to privately held companies.

There are also a number of ETFs focused on small or regional banks, which are quite different from mega banks. In addition to the SPDR S&P Regional Banking ETF mentioned in the prior table, there is also iShares US Regional Banks ETF  and the largely equal-weighted KBW Regional Banking Portfolio .

Going Global

While the world is becoming increasingly inter-connected, there are still diversification benefits to investing outside of U.S. financials. A portfolio with a diverse basket of international financial ETFs is likely to be more sheltered from price shocks occurring in one country, and the potential “scare” in other countries it may cause. Some countries also have very low correlations to U.S. markets, which further aids in diversification .

A broad-based international (non-U.S.) ETF is the SPDR S&P International Financial Sector ETF , and for more region-specific exposure the MSCI Europe Financials Sector Index Fund  or the China Financials ETF .

The Bottom Line

While investors may still have concerns about the financial sector following the 2008 financial crisis, this sector isn’t going anywhere. Several financial ETFs are often top performers, and the sector is much bigger and more diverse than many investors realize. Financial sector ETFs allow you a way to fine-tune your focus on which assets you want to own, and offer great diversification through global, domestic and specific sub-sector investments with various weighting methodologies.

Disclosure: No positions at time of writing.

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