In praising the rise of exchange-traded fund vehicles over the years, we also get to praise the availability of sector ETFs.
For those interested in either trading sectors as a whole or looking to create asset allocation among sectors, using sector ETFs can be an efficient and cost-effective way to do so.
Today, I’m looking at the pros and cons of buying the Financial Select Sector SPDR Fund (NYSEARCA:XLF) — an ETF holding diversified financial companies, from banks like JPMorgan Chase & Co. (NYSE:JPM) to insurers like Berkshire Hathaway Inc. (NYSE:BRK.B). Love ’em or hate ’em, financials are a big part of the global economy and often a core part of any long-term diversified portfolio.
First, the pros of buying the XLF ETF.
Financial SPDR (XLF) Pros
Less Regulation Equals Good Times: There is no question that Dodd-Frank and the Consumer Financial Protection Bureau have resulted in enormous new amounts of regulations heaped upon the financial services industry. There’s no doubt that some portions of the sector were in need of reform and new regulations. However, the government went too far to nobody’s surprise.
One night at a banquet, I asked a guy who worked in the compliance department of a major bank just what percentage of these new regulations were really necessary? He said 60%. That means the rest cost financial services firms time and lots of money.
With Trump as president and already beginning his assault on regulations, that would free up capital to invest, which would bode well for XLF.
Financial Services Are Exploding: I’ve always said that energy was a must-have position in any portfolio. I feel the same about diversified financial services, in the form of XLF. Think about how life everywhere in the world is driven by transactions. Outside of direct cash transactions, every other business transaction requires some form of financial service. The list of services offered and the ongoing innovations just keeps growing. Remember the days before you could tap your smartphone and send money?
Yet, financial services goes beyond just the transactions themselves. There is so much infrastructure and technology beneath the companies in the XLF, that the sector has just become massive. I like to invest in areas that have become an essential part of the human experience, and financial services is one, and thus, so is XLF.
America’s Business Is Business: Under President Trump, there is an additional possible benefit beside fewer regulations. What America has needed for a long time is a businessman as its chief executive. Now we have one. All indications point to the fact that Trump is going to try and make doing business in America easier. Growth in business means growth across the entire financial services sector and in XLF because, as mentioned, the sector is wrapped into our DNA.
Financial SPDR (XLF) Cons
XLF Isn’t Diversified Enough: I love XLF conceptually based on all the pros listed above. However, when we drill into the actual components of the XLF ETF, we find an awful lot of banks. Seven of the top ten holdings are banks or investment banks, accounting for almost 40% of the asset base for XLF. Insurance is represented, and that’s critical.
What I’d really like to see, however, are all the little infrastructure plays that make all these big companies actually operate successfully. They have greater potential for capital gains. So while XLF is good for a base investment in large financial institutions, that’s as far as it goes.
XLF Lags in Performance: The thing about sector ETFs is that their concentration should result in higher volatility than the S&P 500, outperformance in good times and underperformance in bad times. If we look at a chart going back to February of 2007, the S&P 500 is up 60%, but XLF is down 36% — because of the financial crisis.
Since the financial crisis bottom, XLF is up 273%. The S&P 500 is up 208%. That’s not bad, but remember, the XLF also fell further.
No More Real Estate: It wasn’t the fault of the XLF ETF, but sector classifications changed last year. Real estate was pulled out of the financial services sector to create its own stand-alone sector. That meant 20% of the holdings of XLF were yanked out, not only making diversification worse, but removing an essential component of what I consider financial services holdings.
Lawrence Meyers is the CEO of PDL Capital, and manager of the forthcoming Liberty Portfolio stock newsletter. As of this writing, has no position in any stock mentioned. He has 22 years’ experience in the stock market, and has written more than 1,600 articles on investing. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.