The Finance Sector is ranked as #3 among the 15 we cover for year-ahead returns by the ValuEngine forecast model.  Finance sector stocks and ETFs along with the previously profiled utilities sector are generally perceived as stodgy stocks that are most commonly bought by older investors for dividend yield.  However, that has not been true of either sector recently.  The natures of both sectors, finance and utilities, have changed as a result of new technological advancements.  The innovations that have affected the financial sector have been more subtle but no less substantial.

This table compares the 11 Select Sector SPDR ETFs.  These are among the tools most frequently used by sector rotators, asset allocators and hedge funds to take positions in a specific sector of the economy. 

Unsurprisingly, in view of the relentless bull market leadership of technology stocks, the Technology Select Sector SPDR, XLK, is the largest of the group if ranked by assets under management.  Performance would be one reason.  XLK has outperformed S&P 500 Index ETFs, represented here by SPLG, in all three time periods in this table, year-to-date, 1-year and 5 years.  That said, with a VE Rating of 3 (Hold), we expected it to be performing closer to in line with the market during the next one-to-12 months.  Two of its top stocks, Nvidia (NVDA) and Apple (AAPL) are now also ranked 3 (Hold). 

On the other hand, two other Select Sector SPDRs with their largest market cap companies also members of the “Magnificent Seven” are still rated 5 (Strong Buy). Communications Services (XLC) is bolstered by Google (GOOGL) and Netflix (NFLX) even though META  was recently downgraded from 5 to 3.  Consumer Discretionary (XLY) is led by Amazon (AMZN), still rated 5 and Tesla (TSLA) rated 4 in addition to three other Buy or Strong Buy rated stocks among its top 10.  Looking at historical performance, neither XLC nor XLY outperformed SPLG (the S&P 500 Index ETF from SSgA) for the past 5-year period.  XLY has also significantly underperformed SPLG on a year-to-date basis. 

The only Select Sector SPDR that both outperformed in all three time frames and also gets our top rating of 5 for forecasted relative performance is XLF, which represents the Finance sector. It surprised me and may be somewhat surprising to you that XLF is the second largest of the Select Sector SPDR ETFs in total assets and by a wide margin.  With nearly $52 billion, It has more than double the amount of assets in XLC. Using a valuation lens, XLF has a higher dividend yield than XLC, XLK, XLY and SPLG while being priced at a significantly lower P/E ratio than any of these four. 

Eight of the top 10 holdings in XLF are rated 4 (Buy) or 5 (Strong buy).  The strong-buy stocks are Citigroup (C ) and Wells Fargo (WFC).  The buy-rated stocks are JP Morgan Chase (JPM), Visa (VSA), MasterCard (MC), Bank of America (BAC), Goldman Sachs (GS) and Morgan Stanley (MS).  All are US banks or brokerage firms. 

In all, 20 financial sector stocks we cover are rated 5 (Strong Buy) in forecasted performance.  This table shows all 20.  Since they are all top-rated, we ranked this list by our valuation model ranking instead.  We also highlighted the four exceptions to a glaringly obvious trend in the names of the companies on the list.

Please note that the four highlighted companies are the only US domiciled companies on the list.  All of the others are stocks foreign-domiciled financial institutions.  Furthermore, only 3 stocks are in the top 40% of our valuation model’s rank.  The other 17 on the list are classified as between somewhat overvalued to very overvalued.  One thing to take into account is that our valuation model is much more sensitive to the current price and investor is paying for projected future price gains than it is to the historical and often-backward looking ratios commonly favored by  many value investors. Accordingly, there tends to be more of a correlation of our value rank to the PEG (Price-to-Earnings Growth) ratio than to Price/Earnings multiples. 

We’ve noted a few times since midyear that the pronounced fall of the value of the dollar relative to the euro has resulted in US-listed American Depository Receipts (ADRs) to perform much better during the first half of this year than equivalently sized US companies in the same global industry group.  Although the four US-domiciled companies’ stocks performed very well, the top seven 12-month performers were all ADRs of foreign banks.  Since the table is ordered with the most undervalued stocks on top, it should not be a surprise that most of the largest gainers in the past 12 months now rank near the bottom of the list for valuation.  Nonetheless, our predictive model still predicts all twenty to be well-above average performers in the next 1-to-12 month period.  As a bonus, investors in the foreign-domiciled ADRs during the past 12 months also enjoyed a far superior dividend yield.

Although the US-Listed ETF we focused on thus far has been Finance Select Sector XLF, ETFdb.com, our comprehensive source for ETF data from VettaFI, has 48 non-leveraged ETFs that cover the sector.  10 of them are leveraged or inverse which leaves 38 various ways to slice and dice the sector.  This includes ETFs that isolate different industries within the sector such as banking, insurance and capital markets.  Other ETFs hold portfolios of the sector globally or in just one region such as Europe, Asia, Emerging Markets or China.  Some also focus on so-called “smart beta” factors such as high-yield and small market capitalization.  Here is a snapshot of the top ten performing non-leveraged ones during the past 12 months excluding ETFs not available for all five years.

The ETF that defines the Financial Sector for many traders, XLF, placed 13^th in 1-year price gain.  Given our earlier analysis concerning foreign-domiciled large banks, particularly in Europe, it makes sense that the iShares MSCI Europe Financials ETF had the highest gain by a wide margin, nearly 54% or about 2.5 times the robust 21.7% gained by XLF.  That said, a US-only ETF, iShares U.S. Broker-Dealers & Securities Exchanges ETF, IAI, placed second with a 41% price gain. IAI posted at the top for the entire five-year period. EUFN also boasts the highest current dividend yield in this selection, about 3.8%.  The third place finisher targeted only banks. It is Invesco KBW bank ETF, KBWB, with a 33.3% twelve-month price gain and a yield of 2.2%. Our forecast model expects IAI and KBWB to continue their strong relative performance going forward.  Both are rated 5 (Strong Buy). Size is not too much of an issue for most sizes of transactions. KBWB and EUFN also place third and fourth in total assets respectively with $4.6 billion and $4.5 billion.

Both, however, are much smaller than the $52 billion in XLF and the $12 billion in Vanguard Financials ETF, VFH.  The last finished 11^th overall in price gain. Veteran ETF users will not be surprised to see that the expense ratios for these specialty-segment-targeted ETFs are considerably higher than ETFs designed to reflect the entire sector.  In fact, there is a huge spread in expense ratios between the three least expensive, XLF, VFH and FNCL from Fidelity, all at just 8 basis points.  KBWB, an indexes ETF designed by research firm KBW’s analysts is at the low-end of the higher-expense-ratio ETFs at 0.35%.  It would normally be expected given foreign custody and analytic data costs that ETFs holding foreign-listed stocks would charge a higher expense ratio.  This helps explain why the expense ratio of EUFN is higher still at 0.48%.  EUFN still charges less than actively managed DFNL and Global X Fintech ETF FINX with expense ratios above 0.60%. 

Conclusion

ValuEngine’s forecast model is very bullish on the Financial sector, its ETFs and an above-average percentage of the stocks we cover.  That said, many of the individual stocks and the ETFs that hold them are overvalued according to our valuation model although not as overvalued as other sectors such as Technology and Consumer Durables.  The fact that the dividend yields are more generous than those of the major indexes and most other sectors add to the relative attractiveness of the sector.

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