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Last year was a very difficult one for the financial services industry in general and much more so, for the broker-dealer/capital markets segment of the industry. While the broader Dow Jones Financial Index had a negative return of 14.6%, the Dow Jones Select Services Index, which tracks the investment services sector (securities brokers and dealers, online brokers, asset managers and securities or commodities exchanges), had a miserable performance- losing 26.9% during the year. Higher capital and liquidity requirements, difficult funding conditions, uncertain regulatory environment and challenging macroeconomic environment had put a lot of pressure on these companies.

However, recent data related to the housing sector, unemployment and manufacturing shows that the US economy is now on the recovery path. Further, the sovereign debt problems in Europe appear to be contained, as the actions taken by the European Central Bank were successful in providing some respite. As a result, the investors have returned to some of these companies due to their attractive valuation and longer-term growth potential, resulting in an impressive performance this year. (Read-Bank On These Regional Bank ETFs)

The performance of this segment is also highly correlated with the performance of the broader stock markets and a continued recovery in the stock markets will support these companies. Improvement in the stock markets and shifting of the investors’ risk preferences benefits the diversified asset managers while publicly traded exchanges also benefit from the increased trading. (Read- Avoid Turmoil With The Community Bank ETF)

So, if you believe that the economy will continue to improve and the stock markets will continue their upward move this year, now may be a good time to look at some of the ETFs tracking the sector.

We may however, add that big money center sector within this segment are still not out of the woods. On Wednesday, Moody’s Investor Services put 114 global banks (many of them having significant capital market operations) on a review for a possible downgrade in the near future, citing challenges posed by the European credit crisis, interconnectedness, and difficulty accessing capital as the major reasons for the possible downgrade. Though the downgrade threat did not have much effect, the fact remains that these companies will continue to face evolving challenges in near-to-medium term. But we believe that with improved capitalization levels and risk management practices, these companies are better positioned for longer-term. (Read- Top Three High Yield Financial ETFs)

iShares Dow Jones U.S. Broker-Dealers Index Fund (IAI - ETF report)

IAI tracks the Dow Jones U.S. Select Investment Services Index which measures the performance of the investment services sector of the U.S. equity market. It includes securities brokers and dealers, online brokers and securities or commodities exchanges. The fund has assigned highest weighting to Goldman Sachs (8.58%) followed by and Morgan Stanley (7.62%) and CME Group (6.97%). Top 10 holdings account for more than 58% of the portfolio. Created in May 2006, this fund currently has 25 holdings and an expense ratio of 0.47%.The ETF took a strong beating last year with a return of negative 27.16% but has returned an impressive 12.7% this year-to-date.

SPDR S&P Capital Markets ETF (KCE - ETF report)

The ETF tracks S&P Banks Select Industry Index that comprises of broker-dealers, asset managers, trust and custody banks or exchanges.

Janus Capital Group (3.19%), Jefferies Group (3.17%) and Lazard Ltd (3.14%) are the top holdings, while 30.46% of the portfolio assets are invested in top ten stocks. This ETF currently has 45 holdings and an expense ratio of 0.35%.

PowerShares KBW Capital Markets Portfolio (KBWC - ETF report)

This ETF tracks the KBW Capital Markets Index which is comprised of broker-dealers, asset managers, trusts and custody banks and exchanges.

State Street Corp. (8.88%), Morgan Stanley (7.63%) and Goldman Sachs (7.37%) enjoy the highest weightings in the portfolio. Created very recently (November 2011), this ETF currently has 24 holdings and an expense ratio of 0.35%.

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