Financial services ETFs
The market has produced some ugly headlines this year, but in no area have things been more gruesome than in financial services.
It started with the subprime mortgage mess, continued into the credit crunch, and got whipped into a frenzy with bad news at Citigroup, Morgan Stanley and Washington Mutual.
Some investors view that bad news as an obvious danger sign of what lies ahead; others see it as opportunity.
If you’re an average investor, side with the first group, as investing broadly in the financial-services sector in the form of the Financial Select Sector SPDR, the iShares Dow Jones U.S. Financial Services Index or the iShares Dow Jones U.S. Financial Sector Index - would be the Stupid Investment of the Week.
Stupid Investment of the Week showcases the conditions and characteristics that make securities less than ideal for the average investor, and is written in the hope that spotlighting problems in one situation will make it easier to sniff out danger elsewhere.
The column is not intended as a sell signal, as there may be times when unloading a problem investment compounds the trouble.
In the case of the financial-services ETFs, it’s true that average investors capable of riding out a long storm could be rewarded for their patience. The problem is that bargain hunters are jumping into the blizzard before the conditions have reached their most extreme.
“The value guys are out there pushing financial services, and there are a lot of computer models chasing value here,” said Dave Fry, editor of ETF Digest, which has recommended a short position on some financial-services ETFs. “They’re looking at the situation and saying, ‘Wow, it’s trading at book value right now’ ” Fry said. “But this has a long way to go before it’s played out. Right now, it’s one of those ‘catch a falling knife’ deals.”
It’s hard for me to agree with that kind of assessment, because my own personal bent is toward value - looking for the companies that have been beaten up and that can be purchased on sale - and favors financial stocks.
That said, the near-term outlook for the financial sector is gruesome, and even a value-oriented investor needs to recognize that sometimes investments are cheap because that’s precisely what they deserve for a while.
“Aside from the homebuilders, the financial ETFs are the cheapest ones on our radar screens,” said Sonya Morris, editor of the Morningstar ETFInvestor newsletter. “If you’re a bargain hunter, you need to step in where everyone else is panicking, and this could be one of those times. But you also need to recognize that these are times that will test the temperament of investors, so you need to have the right kind of long-term outlook.”
A major consideration for average investors is that the short- and mid-term outlooks for financial services stocks are murky. The depth and breadth of the problems seem to chang on a daily basis.
There’s little doubt, however, that the sector will rise and fall with the fortunes of Citigroup, and executives of that company have made it obvious that the picture there won’t clear up completely for months.
In the meantime, speculation about whether the dividend will be cut, what will happen with performance and how bad the first-quarter outlook really is will make the stock - and the sector - volatile.
Citigroup represents roughly 8.5 percent of the Financial Select Sector SPDR, and is nearly 11 percent of the IYG. It’s almost 7 percent of the IYF.
Citi, Merrill Lynch, Morgan Stanley, American International Group and Freddie Mac have all been hammered in the headlines and on the market; each is off at least 19 percent this year.
Combined, those five stocks are at least 16.5 percent of the three financial ETFs; they make up more than 20 percent of the XLF.
Not surprisingly, all three of the ETFs have lost more than 15 percent year-to-date, which means that the diversification of buying a fund - rather than an individual stock - has not been a huge help.
In short, this is one case where bargain-hunting on individual stocks might be a better idea than betting on the whole industry.
“Citigroup is very different to me than Freddie Mac and Americredit, and if you buy an ETF, you are getting them all,” says Don Yacktman, the deep-value style manager of the Yacktman Fund, who holds the latter two but is dour about the prospects of Citi. “You don’t just buy something because it’s down. That’s a good way to have your head handed to you, and the market is clearly hurting a lot of financial services companies, so you want to know which ones have real problems and which ones are just falling with the tide right now.”
Many of the same criticisms that apply to the three ETFs winning this week’s award could also be used on other funds that track various parts of the sector, such as regional banks or insurance companies, although the portfolio make-up is different.
While no one expects the financial-services business to be down forever, the real question for investors is whether they’re willing to ride out the pain as the sector establishes a new bottom and struggles to start a recovery.
“You’re buying an industry which you know has had major problems and where you have no idea how the problems are being solved,” says Walter Frank, chief investment officer at Moneyletter. “The element of uncertainty is getting you a price that’s attractive, but it is also what you have to fear. You have to be absolutely certain that you can deal with the uncertainty.”
Chuck Jaffe is senior columnist for MarketWatch. He does not own or hold short positions in any securities covered by Stupid Investment of the Week. If you have a suggestion for Chuck Jaffe’s Stupid Investment of the Week or a comment about this week’s column, you can reach him at jaffe@marketwatch.com or Box 70, Cohasset, MA 02025-0070.