Wall Street Shuffle: Despite Poor Start To ’11, Financial ETFs Earn Closer Look

By Brian O’Connell

Let’s get the bad news out of the way first.

Financial service exchange traded funds (ETFs) haven’t had a banner year so far. How bad is it? Put it this way – if financial ETFs were a major league baseball team, they’d be the Mets.

According to the Russell 2000 Index, financial ETFs were the worst-performing sector through April 30, gaining only about 2.8%. That performance could grow worse if economic trends in May and early June continue – trends like more mortgage losses for lenders, declining housing sales for real estate insurance trusts (REITs), and shaky balance sheets for “too big too fail” banks and regional banks.

The professional investing class says the finance sector is a risky one. “Investing in the financials sector needs a strong risk tolerance and the understanding that the sector is in recovery mode and will be susceptible to setbacks if the economy falters,” notes Timothy Strauts, a Morningstar equities analyst, in a recent research report.

As Strauts attests, if the stock market decline that was triggered on June 1st continues, financial stocks could really take a hit.

But as any savvy money manager knows, investing is a cyclical – and a long-term process. If financial services ETFs are low relative to other stock sectors, then that makes them a much better buying opportunity if you believe a solid economic recovery is right around the corner (admittedly a big “if”).

So how do you play financial ETF’s, if and when you pour some money into that corner of the stock market? For starters, a little education on what financial ETFs are; how they work, what their benefits are, and what ETFs are a good bet might be in order.

What are financial ETFs?

Financial ETFs are baskets of stocks (traders call them “indexes”) from the financial sector. Here’s a thumbnail view:

  • Most ETFs focus on stocks in the banking, REIT, broker-dealer, asset management, insurance, and mortgage lending markets.
  • Financial ETFs come in four “varieties”: global, US or emerging market, industry sub-groups, and vertical finance industry groups (like insurance companies or regional banks).
  • If you dig deeper, you can find sector ETFs that are more exotic, but which offer more risk and more reward. Examples include leveraged ETFs, quant strategy ETFs, and inverse ETFs. Suffice to say, they’re not recommended for the novice, or even relatively seasoned individual investor.

ETFs from the money and banking worlds are really no different, operationally, than any other ETFs.

They are traded (just like stocks) on the New York Stock Exchange. Financial ETFs mirror mutual funds in some ways – they are a collection of stocks in one basket – but they are easier to buy and sell, and offer better deals for investors on taxes and fees. On the latter point, mutual funds charge about 0.95% in fees in 2010 (including indexed and actively managed funds). Compare that to the 0.50 %fess linked to most financial ETFs. The iShares Financial Sector ETF’s annual fee, for example, is a paltry 0.48%

Tax-wise, finance ETFs, like most ETFs, come in lower than buying mutual fund shares or individual stocks. When ETF managers sell, they’re not selling any underlying assets, as mutual fund managers or stockbrokers do. By not generating any capital gains, ETF managers can save money via lower tax liabilities.

Why financial ETFs?

The finance sector is a classic example of a volatile market, with economic indicators, new government regulations, a rise in investor and state attorney general lawsuits, and stock market price swings from big-time speculators all capable of making finance stocks vibrate like a 20-foot tuning fork.

That inherent volatility makes financial ETF’s a lower risk play than individual stocks in the finance sector. It’s all about diversifying your investments, so instead of pouring all of your assets into Bank of America (Stock Quote: BAC); and ETF allows you to add JP Morgan Chase (Stock Quote: JPM); Citi (Stock Quote: C) and some regional banks into the mix, thus spreading your risk around.

Think about it. If Bank of America is hit with a lawsuit or regulatory fines, the stock price usually goes down. But that doesn’t mean other big banks are taking it on the chin from an appellate court judge or from a regulator at the FDIC. In that regard, financial ETFs are hedges against the kind of volatility that usually attaches itself to the finance sector like a barnacle to the hull of a boat.

How to play financial ETFs

A mix of various finance industry groups (say banks, insurance, and REITs) is a good diversification tactic when you’re popping some cash into a sector ETF. By and large, the finance sector rises and falls equally, but in many instances, insurance companies can out-perform REITs, while REITs can outperform banks and brokers. A good finance ETF that comprises all three industry sectors can protect you on the downside, but give you plenty of opportunity on the upside.

You might even want to take that strategy one step further, by investing in several broad categories of financial ETFs; say a global finance ETF and a U.S. financial ETF. That move helps provides additional risk protection.

What are some of the best finance ETFs?

Here’s a good list of financial ETFs, broken down by sector and by ETF

Sector: Global Finance

ETF Pick: iShares S &P Global Financials Sector Index Funds (Stock Quote: IXG)

Sector: Bank ETFs

ETF Pick: iShares Dow Jones Regional Banks Index Fund (Stock Quote: IAT)

Sector: US Financials

ETF Pick: Vanguard Financials ETF

Sector: Insurance ETFs

ETF Pick: Powershares Dynamic Insurance Portfolio (Stock Quote: PIC)

Sector: Broker-Dealers

ETF Pick: KBW Capital Markets ETF (Stock Quote: KCE)

Let’s face facts. Demand for products from banks, insurance companies and other financial services companies isn’t abating. To get your share of a huge market, play financial ETFs, and leave the risk to the big institutional fat cats.