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The financial sector has been on the mend for quite some time and is expected to continue as one of the top performing sectors in the coming months. As a result of increased oversight, improved capital levels and better risk management systems, the industry is now in a much better shape than it was five years back.
Last month, Moody’s changed their outlook on US banks to “stable” from “negative”. According to the rating agency “sustained GDP growth and improving employment conditions will help banks protect their now-stronger balance sheets”.
Per Zacks estimates, finance sector earnings are expected to increase 19.1% during the second quarter from the prior-year quarter. Further, while the revisions trend for the S&P 500 as a whole continues to be neutral, finance sector revisions trend has been positive. (Read: 3 Impressive biotech ETFs crushing the market)
FDIC insured banks reported a record profit of $40.3 billion in the first quarter of 2013, up 15.8% from the first quarter of 2012. Further, the number of banks on the problem list continued to decline and only four banks failed during the quarter—the lowest since 2008. (Read: Buy these ETFs for dividend growth)
The picture doesn’t look so good if we dig deeper into earnings’ quality. About a quarter of profits earned by the top five banks was a result of loan loss reserve release according to an analysis by SNL financial. Cost cutting was another important contributor to the bottom line.
However, the quality of earnings will improve as the economic picture brightens further. And as the health of banks’ loan portfolio continues to improve, they will need less loan loss reserves in future. Further, as the yield curve steepens, expanding net interest margins will bolster banks’ profits.
Another reason to be bullish on the financial sector is its potential for increasing dividends and buybacks. Financials have accounted for the largest increase in dividends in the last three years, per WisdomTree. This year so far has already been excellent in terms of dividends/buybacks increases by finance companies as many of them got Fed approval after passing stress tests.
Risks include rising interest rates which could slow down mortgage origination as well as refinancing activities, though decline in refinance will be partly offset by expanding net interest margin. (Read: 3 important questions about your ETF portfolio)
Further, regulatory costs may continue to climb up and exposure to banks in Europe also remains a risk for bigger banks.
Vanguard Financials ETF (VFH - ETF report)
With an expense ratio of just 19 basis points, VFH is a cheap way of getting a diversified exposure to financial services companies.
Launched in January 2004, this ETF is now home to $1.4 billion in assets. The product holds 515 stocks in its basket with highest allocations to Wells Fargo, J P Morgan and Citigroup. The fund's dividend yield is 1.88% as of now.
VFH is currently a Zacks Rank #1 (Strong Buy) ETF.
S&P Financial Select Sector SPDR Fund (XLF - ETF report)
The largest and the cheapest fund within the financials space--XLF tracks S&P Financial Select Sector Index. Launched in December 1998, this fund has attracted more than $13.8 billion in assets.
The product holds 82 securities in its basket, with top allocations to Berkshire Hathaway, JP Morgan and Wells Fargo. It charges an expense ratio of just 18 basis points and has a dividend yield of 1.50% currently.
XLF is currently a Zacks Rank #2 (Buy) ETF.
RevenueShares Financials Sector Fund (RWW - ETF report)
RWW holds the same securities as the S&P 500 Financials Index but these 81 securities in the fund are ranked by their revenue, instead of market capitalization. Berkshire Hathaway, JP Morgan and Bank of America are the top holdings currently.
The index and the fund have been outperforming their market cap weighted cousin but the outperformance comes with slightly higher expense ratio of 49 basis points.
RWW is currently a Zacks Rank #1 (Strong Buy) ETF.
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