Best & Worst ETFs & Mutual Funds: Financials Sector

The Financials sector ranks last out of the ten sectors as detailed in my sector rankings for ETFs and mutual funds. It is the only sector to get my Very Dangerous rating, which is based on aggregation of ratings of 46 ETFs and 232 mutual funds in the Financials sector as of October 11, 2012. Prior reports on the best & worst ETFs and mutual funds in every sector and style are here.

Figures 1 and 2 show the five best and worst-rated ETFs and mutual funds in the sector. Not all Financials sector ETFs and mutual funds are created the same. The number of holdings varies widely (from 23 to 504), which creates drastically different investment implications and ratings. The best ETFs and mutual funds allocate more value to Attractive-or-better-rated stocks than the worst ETFs and mutual funds, which allocate too much value to Neutral-or-worse-rated stocks.

To identify the best and avoid the worst ETFs and mutual funds within the Financials sector, investors need a predictive rating based on (1) the stocks ratings of the holdings and (2) the all-in expenses of each ETF and mutual fund. Investors need not rely on backward-looking ratings. My fund rating methodology is detailed here.

Investors should not buy any Financials ETFs or mutual funds because none get an Attractive-or-better rating. If you must have exposure to this sector, you should buy a basket of Attractive-or-better rated stocks and avoid paying undeserved fund fees. Active management has a long history of not paying off.

Get my ratings on all ETFs and mutual funds in this sector on my free mutual fund and ETF screener.

* Best ETFs exclude ETFs with TNA’s less than $100 million for inadequate liquidity.

PowerShares KBW Capital Markets Portfolio KBW, SPDR S&P Capital Markets ETF KCE and iShares Dow Jones U.S. Broker-Dealers Index Fund IAI are excluded from Figure 1 because their total net assets (TNA) are below $100 million and do not meet our liquidity standards.

Figure 2: Mutual Funds with the Best & Worst Ratings – Top 5

ICON Funds: ICON Financial Fund ICFSX is excluded from Figure 2 because its total net assets (TNA) are below $100 million and do not meet our liquidity standards.

iShares FTSE NAREIT Mortgage REITs Index Fund REM is my top-rated Financials ETF and Davis Series, Inc: Davis Financial Fund (DVFYX) is my top-rated Financials mutual fund. Both earn my Neutral rating.

iShares FTSE NAREIT Industrial/Office Capped Index Fund FNIO is my worst-rated Financials ETF and Rydex Series Funds: Real Estate Fund RYREX is my worst-rated Financials mutual fund. Both earn my Very Dangerous rating and should be avoided.

Figure 3 shows that 84 out of the 571stocks (over 14.7% of the total net assets) held by Financials ETFs and mutual funds get an Attractive-or-better rating. However, no Financials ETFs and no Financials mutual funds get an Attractive-or-better rating.

The takeaway is: too many Financials sector mutual fund managers and ETFs are picking the wrong stocks. Their fees are undeserved, no matter how low.

As detailed in “Cheap Funds Dupe Investors”, the fund industry offers many cheap funds but very few funds with high-quality stocks, or with what I call good portfolio management.

Investors need to tread carefully when considering Financials ETFs and mutual funds, as only 1 ETF and 1 mutual fund earn a Neutral rating and should be held. All of ETFs and mutual funds should be sold. None of the Financials ETFs or mutual funds in the Financials sector allocate enough value to Attractive-or-better-rated stocks to earn an Attractive rating, so investors seeking exposure to the Financials sectors should focus on the 72 stocks that earn and Attractive-or-better rating.

Credit Acceptance Corp CACC is one of my favorite stocks held by Financials ETFs and mutual funds and earns my Very Attractive rating. CACC has a proven track record of effective capital stewardship with a return on invested capital (ROIC) of 28% in 2011, which places the company in the 94th percentile of all Russell 3000 companies. CACC is not only a good company; it is also an attractive stock due to the market’s pessimistic view of future cash flows. The company’s current stock price (~$84.20) implies that after-tax profits (NOPAT) will permanently decrease by 23%. This seems unlikely given that the company has increased its profits by an average of 32% over the past five years. Low expectations and strong historical performance make CACC an excellent long candidate.

Health Care REIT, Inc. HCN is one of my least favorite stocks held by Financials ETFs and mutual funds and earns my Very Dangerous rating. In the worst sector, HCN is one of the worst stocks. HCN has misleading earnings – its economic earnings are negative and declining while its reports accounting earnings are positive and increasing. Only twice during the 14 years in my model has the company generated positive economic earnings, with 2008 being the most recent period. Not only is HCN not profitable, it is also overvalued. To justify its current stock price (~$59.56), the company must increase profits by 14.1% compounded annually for 34 years. That is a lot of future value creation for a company that has mostly destroyed value. Investors should avoid this stock.

Figures 4 and 5 show the rating landscape of all Financials ETFs and mutual funds.

Our sector rankings for ETFs and mutual funds report ranks all sectors and highlights those that offer the best investments.

Review my full list of ratings and rankings along with reports on all 46 ETFs and 232 mutual funds in the Financials sector.

Disclosure: I own CACC. I receive no compensation to write about any specific stock, sector or theme.