The results of the much awaited Federal Reserve's annual test of the big banks' financial health indicate a brighter picture than last year. The stress test – first conducted in 2009 after the collapse of big financial institutions like Lehman Brothers and American International Group, Inc. – is an important tool used by the financial regulators to gauge whether the country’s financial system can withstand extreme adverse economic conditions in the future.
In the latest review, 29 of the 30 banks cleared the Fed test, indicating that the vast majority of the country’s largest financial institutions have enough capital to withstand severe losses during times of market turmoil.
The most surprising outcome of the test was that the smaller banks fared better than much bigger names like Citigroup Inc. ((C - Analyst Report)), JPMorgan Chase & Co. ((JPM - Analyst Report)) and The Goldman Sachs Group, Inc. (GS). Zions Bancorporation ((ZION - Analyst Report)) with Tier 1 common capital ratio of 3.5%, was the only bank to fail to meet the minimum requirement of 5%.
State Street Corp. (STT), with a Tier 1 common capital ratio of 13.3%, topped the list, and was followed by The Bank of New York Mellon Corp. (BK) and Discover Financial Services (DFS), each having a ratio of 13.1%.
The test was based on 28 variables affecting the global domestic economy, including a drop in housing prices, a sharp 50% slump in equity prices, and a spike in unemployment.
The Fed stress test thus signifies that at present American banking giants are better-positioned to withstand a severe economic downturn should it happen.
Moreover, with an interest rate hike in the cards down the line, the broad financial sector, including banks and insurance, are expected to benefit from rising rates (read: Play Rising Rates with These ETFs).
With enough capital in their coffers, the banks look good and so does the financial sector at large. For an ETF approach, one can add any of the below mentioned funds for diversified exposure to the sector.
Financial Select Sector SPDR Fund ((XLF - ETF report))
The fund tracks the S&P Financial Select Sector Index, giving investors exposure to the U.S. financial space.
The fund holds a basket of 84 stocks with the top three holdings – Wells Fargo & Company, JPMorgan Chase & Co. and Berkshire Hathaway Inc. Class B – each receiving about 8% of the portfolio. The fund also includes some of the well-known banks such as Bank of America Corporation, Citigroup Inc. and Goldman Sachs Group Inc. in its top ten holdings.
Sector-wise, banks occupy around 39% of fund assets, followed by insurance (17.35%) and capital markets (13.19%) (see all Financial ETFs here).
The fund has returned 25% in the past one year and have added 2.3% so far this year. Also with an expense ratio of 18 basis points, XLF is one of the cheapest in its space. The ETF currently carries a Zacks ETF Rank #1 or ‘Strong Buy’.
RevenueShares Financials Sector Fund (RWW - ETF report)
The fund holds the same securities as the S&P 500 Financials Index. However, it presently holds only 81 stocks, which are ranked by their revenues, instead of market capitalization.
Berkshire Hathaway, JP Morgan and Bank of America are the top holdings currently. The fund gained a stellar 42% during 2013, while adding 1.8% since the start of the year.
RWW currently has a Zacks ETF Rank #1 (Strong Buy) (read: 3 Top Ranked ETFs from Hottest Sectors).
PowerShares KBW Capital Markets Portfolio (KBWC)
This often overlooked fund manages an asset base of $9.8 million and tracks the KBW Capital Markets Index.
The index tracks the performance of companies that do business as broker-dealers, asset managers, trust and custody banks or exchanges that are publicly traded. This focus results in the fund holding a small basket of 24 stocks.
State Street Corp., which topped the stress test, occupies the fourth spot in the fund with 7.8% allocation. Morgan Stanley and Goldman Sachs are two other banks listed in the top ten of the fund (Read: Best ETF Strategies for 2014).
The fund currently carries a Zacks ETF Rank #2 (Buy) and has returned 27.28% in the past one year.
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