Finding Value In Bank ETFs

There is often a fine line between legitimate value and value traps. Where the laggard financial services sector and its corresponding exchange-traded funds fall this year is up for debate, but there is no debating that the S&P 500's second-largest sector weight is a dud to this point in the year.

Recent Banking Performance

Even with the benefit of some recent upside, the Financial Select Sector SPDR Fund XLF, the largest financial services ETF, is up a piddly tenth of a percent this year. The PowerShares KBW Bank Portfolio ETF KBWB, which tracks the oft-cited KBW Nasdaq Bank Index, is lower by nearly 7 percent.

Arguably the most obvious issue plaguing KBWB, XLF and other financial services ETFs is the Federal Reserve's refusal to boost interest rates. However, the Fed recently provided some good news with the release of the most recent Comprehensive Capital Analysis and Review (CCAR) results.

The results of the Fed's CCAR open the door for XLF holdings to increase dividends and buybacks, an important factor when considering many XLF's holdings, although sources of dividend growth in recent years, still sport payouts below those seen prior to the financial crisis.

Related Link: Financial Services ETFs Searching For Momentum

Higher dividends and increased buybacks are usually met with enthusiasm, but those treats, however sumptuous, do not erase financials' laggard status this year.

“For example, from January 1st until this last Thursday, when the first major bank reported earnings, the KBW Bank Index (BKX) dropped -9 percent,” said Rareview Macro founder Neil Azous in a note out Tuesday. “Conversely, during that same period, the S&P 500 appreciated by +5 percent. Therefore, the relative underperformance of banks to the S&P 500 was ~14 percent YTD. That is significant when thinking about sector performance on annualized basis (i.e .~28 percent).”

The Fed Factor

The Fed is almost universally viewed as one of the most determinants of performance for ETFs such as XLF and KBWB, but the central bank does not appear likely to oblige as bonds markets are pricing in diminishing odds of even one rate hike before the end of this year. That deals a blow to a sector and its ETFs that came into 2016 with hopes of up to four rate hikes.

That is probably one reason why investors are significantly underweight financials. Citing the recent Global Fund Manager Survey (FMS) by Bank of America Merrill Lynch (BAML), Azous points out that respondents to the survey are the most underweight bank stocks that they have been since 2012.

Outflows from XLF jibe with that assessment as the ETF has shed nearly $3.6 billion year-to-date. Still, the sector could be primed for a technical, particularly when considering its poor status relative to the S&P 500.

“All we are saying is that the intersection above of yields, earnings, and positioning is going to make a few portfolio managers play the field, especially relative to the S&P 500,” added Azous.

Disclosure: Todd Shriber owns shares of XLF.