The fund industry offers excellent choices for investors interested in diversifying their portfolios with exchange-traded funds (ETFs). Due to the weak performance of the financial sector, however, only two ETFs in this sector have managed to receive positive cash inflows year-to-date as of March 4, 2016. These are the Vanguard Financials ETF (NYSEACRA: VFH) and the PowerShares S&P SmallCap Financials Portfolio ETF (NASDAQ: PSCF).

Financial Sector Performance

Despite elevated optimism in the investment community throughout 2015 from the prospects of rising interest rates in the United States, the financial sector underperformed the overall stock market. As of Feb. 29, 2016, the S&P Financial Select Sector Index showed a year-to-date (YTD) loss of 11.53% and a one-year loss of 11.60%. In contrast, the S&P 500 Index posted a YTD loss of 5.09% and a one-year loss of 6.19%.

In December 2015, the U.S. Federal Reserve raised the target federal funds rate range by 0.25%, bringing it to a range of 0.25% to 0.50%. With prospects of further interest rate hikes remaining unknown, the modest increase in the benchmark rate is likely to have a muted effect on the financial sector. Banks' profits are typically influenced by net interest margins, rather than the level of interest rates per se. If net interest margins remain the same, there is little effect on banks' valuations. Also, major banks experienced a high degree of regulatory scrutiny in 2015, and most banks' compliance costs increased dramatically. Legal costs were also a major headwind for several large banks, which were fined for financial manipulation. While banks had a much better capitalization at the end of 2015 compared to 2008, their returns were also diminished greatly as a result of more capital set aside for regulatory reasons.

Vanguard Financials ETF

Based on year-to-date fund flows as of March 4, 2016, the Vanguard Financials ETF managed to gain about $140 million and had about $3.4 billion in AUM. Started in January 2004, the fund tracks the performance of the MSCI US Investable Market Financials 25/50 Index, which is composed of stocks of companies in the financial sector. The fund offers a one-stop diversified exposure to the U.S. financial sector. As of Jan. 31, 2016, the fund had 568 holdings in its portfolio. Stocks of diversified banks had the largest allocation of 23%, while equities of regional banks and of property and casualty insurers had 10.1% and 6.7% allocations, respectively. The top 10 holdings of the fund represented 34.1% of its portfolio.

As of Feb. 29, 2016, the fund showed a YTD loss of 10.77% and a one-year loss of 10.57%. For the three-year period, the fund demonstrated an average annual return of 7.71%, a standard deviation of 12.26% and a Sharpe ratio of 0.66. For the five-year period, the fund exhibited an average annual return of 6.67%, a standard deviation of 15.49% and a Sharpe ratio of 0.49. The fund comes with an expense ratio of 0.10% and has a three-star overall rating in the financial category.

PowerShares S&P SmallCap Financials Portfolio ETF

PowerShares S&P SmallCap Financials Portfolio ETF increased its AUM by $15 million from Dec. 31, 2015, to March 4, 2016. Started in April 2010, this ETF now has about $187 million in AUM. It tracks the performance of the S&P SmallCap 600 Capped Financials Index, which is composed of stocks of small-cap financial companies. As of March 10, 2016, the fund had 119 holdings and allocated its assets to stocks of banks at 37.20% allocation, real estate investment trusts (REITs) at 31.96% and insurance companies at 12.32%. The fund's portfolio is well-diversified, and its top 10 holdings account for 17.81% of its assets.

As of Feb. 29, 2016, the ETF showed a YTD loss of 6.85% and a one-year loss of 5.51%. The fund demonstrated an average annual return of 7.04%, a standard deviation of 13.48% and a Sharpe ratio of 0.57 for the three-year period. For the five-year period, the ETF generated an average annual return of 8.73%, a standard deviation of 14.60% and a Sharpe ratio of 0.64. The fund charges an expense ratio of 0.29% and has a four-star overall rating from Morningstar in the financial category.

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