Why Financial ETFs Could End Their Run Of Disappointment

The Financial Select Sector SPDR XLF is up 15.28% year to date and while that sounds pretty good (it is), XLF and rival financial services exchange traded funds are trailing the S&P 500 this year.

What Happened

Much of the story with financial services ETFs revolves around interest rates. The sector disappointed last year even as the Federal Reserve raised four times. This year, the group has rebounded, but has been mostly range-bound over the past several months after the Fed trimmed lending rates in July and again in September.

A prominent theme on second-quarter earnings calls from large money center banks, including some marquee XLF constituents, was management discussing expected declines in net interest margins as the Fed embarked on rate cuts.

“With funding sources for financials, such as bank deposits, often linked to short-term interest rates and certain interest-earning assets, such as mortgage loans, tied to long-term rates, a flat or inverted yield curve can pressure net interest income,” said Morningstar in a recent note.

Why It's Important

In defense of financials, the sector is undoubtedly a value destination that's home to steadily rising dividends and massive share repurchase plans. Whether that's enough to entice investors against the backdrop of falling interest rates remains to be seen.

But not every member of the sector is a credible value play. Some may have company-specific woes that could keep investors at bay.

“Most of the undervalued financial stocks in North America either have company-specific issues that we believe the market isn’t appropriately pricing or are more economically sensitive names,” according to Morningstar. “While there are near-term risks to the companies we currently regard as undervalued, they also have the greatest probability of long-term outperformance.”

What's Next

Among the XLF components that look attractive right now is Warren Buffett's Berkshire Hathaway (NYSE: BRK-B). Fortunately, that's XLF's largest holding at 13.07% of the ETF's weight.

“Berkshire has plenty of cash on hand and a disciplined share-repurchase program,” said Morningstar. “The shares are currently trading at a deep enough discount to our $380,000 ($253) per Class A (B) share fair value estimate, equivalent to 1.25 times our estimated end of 2019 book value per share, to warrant the attention of long-term investors.”

Disclosure: The author owns shares of XLF.

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