Capital Markets ETFs Maybe Not Capital Ideas

Widely documented have been the struggles of the financial services sector this year. The Financial Select Sector SPDR XLF, although that exchange traded fund has recently rallied, is off 1.6 percent year-to-date.

Some other ETFs tracking parts of the second-largest sector weight in the S&P 500 have lagged XLF in significant fashion. Blame Wall Street. Seriously, ETFs dedicated to brokerage houses and capital markets firms have lagged broader financial services ETFs like XLF in a big way this year.

Just look at the iShares U.S. Broker-Dealers & Securities Exchanges ETF IAI and the SPDR S&P Capital Markets ETF KCE. The average year-to-date loss for those ETFs is more than eight percent. In the essence of fairness, it should be noted that KCE and IAI are up 9.4 percent and 4.8 percent, respectively over the past 90 days.

Adding to the near-term problems for U.S. bank stocks and ETFs like XLF is that when the sector climbed last year as investors were betting on the Federal Reserve raising interest rates, the group became expensive on valuation. Capital markets ETFs face Fed issues and some other problems.

“Volatile markets over the past several months subdued new debt and equity issuance and weighed on the performance of trading businesses, signaling a challenging start toward full-year results,” said Fitch Ratings in a recent note. “Overall capital markets net revenue for the five US Global Trading and Universal Banks (GTUBs) down 22% in 1Q16 from the particularly strong prior-year quarter. However, overall capital markets net revenue rose 18% from the sequential quarter as the fourth quarter tends to be slower.”

As a cap-weighted ETF, IAI is more sensitive to negativity for capital markets firms because the fund is dominated by two stocks. Goldman Sachs Group Inc. GS and Morgan Stanley MS combine for 20.6 percent of the ETF's weight.

KCE is an equal-weight ETF where none of its 46 holdings command more than 3.1 percent of the fund's weight. Interestingly, KCE can be viewed as the ETF of the ETF industry as roughly a quarter of the ETF's holdings are either issuers or involved in the ETF industry in another capacity.

“More significantly, results from the Fixed Income Currencies and Commodities (FICC) businesses, which are the largest components of overall capital markets revenues, remained challenging, notably in the credit, mortgage and securitized products areas,” adds Fitch. “As a result, the US GTUBs continue to examine the amount of resources devoted to FICC given the level of fixed costs and the amount of capital that must be held in the business. There have been headcount reductions in FICC across all of the firms so far this year, and management teams have indicated that more could be forthcoming in the event that market conditions do not begin to improve more meaningfully.”

Disclosure: The author owns shares of XLF.