Pressured by low interest rates, financial stocks are disappointing investors in a big way this year. For example, the Financial Select Sector SPDR Fund (NYSEARCA:XLF) – the largest financial ETF – is down 25.37% year-to-date while the S&P 500 is off just 3%.
Low interest rates suppress banks’ net interest margins (NIM), or the difference between the interest banks make on loans and what must be paid out to depositors. The depressed NIM scenario was an issue for banks last year, but it was exacerbated earlier this year when the Federal Reserve took rates to near zero in response to the novel coronavirus pandemic.
The erosion in market value in the financial services sector is palpable. As recently as last year, the group was the third-largest sector weight in the S&P 500. These days, it resides in the fifth spot and that’s not the end of the sector’s struggles.
More recently, the Federal Reserve revealed the results of its annual stress test and the message was clear: the largest U.S. banks can’t raise dividends or engage in buybacks. Wells Fargo (NYSE:WFC) even pared its payout to conserve cash for bad loans.
On the upside, the Fed eased the Volcker Rule, potentially setting the stage for banks to deploy capital into alternative investments. Additionally. Financial services is one of the least expensive sectors, perhaps indicating the following financial ETFs offer investors some value:
- ARK Fintech Innovation ETF (NYSEARCA:ARKF)
- Invesco S&P SmallCap Financials ETF (NASDAQ:PSCF)
- VanEck Vectors BDC Income ETF (NYSEARCA:BIZD)
Financial Stocks to Buy: ARK Fintech Innovation ETF (ARKF)
Expense ratio: 0.75% per year, or $75 on a $10,000 investment
While the traditional financial services sector is scuffling this year, its disruptive fintech counterpart is doing the opposite. Just look at the ARK Fintech Innovation ETF, which as of July 2 is up a stellar 45% year-to-date. As noted above, many old school bank stocks are being hamstrung by the Covid-19 pandemic, but ARKF holdings, such as PayPal (NASDAQ:PYPL) and Square (NYSE:SQ), are thriving amid the chaos.
For example, the virus is accelerating the shift to contactless payments, a boon for the likes of Square, PayPal and other fintech companies.
“The market assumes that COVID-19-related adoption of digital payments is a near-term benefit for Payments providers, offsetting some of the consumer spend headwinds,” said Morgan Stanley in a research note. “However, digitization of Payments is part of a multi-year secular growth driver in Payments, with COVID-19 as just the latest accelerator.”
Then there’s the emergence of digital wallets, such as PayPal’s Venmo and Square’s Cash App. Essentially, digital wallets are smartphone-based apps that provide many of the same functions as traditional banks at a fraction of the customer acquisition cost.
Invesco S&P SmallCap Financials ETF (PSCF)
Expense ratio: 0.29% per year
The Invesco S&P SmallCap Financials ETF is a traditional financial services ETF and its year-to-date loss of 32.17% is reflective of that status. With that statistic in mind, it would be easy to write off PSCF and focus on other opportunities, but investors may not want to be so hasty.
There are overt signs of life with small-cap stocks. Over the past three months, the S&P SmallCap 600 Index, the index in which PSCF components reside, is outpacing the S&P 500 by almost 400 basis points. Another point in favor of this financial ETF is that the Fed typically doesn’t dictate dividend policy to smaller banks. PSCF yields 5.87%, or 405 basis points more than the S&P SmallCap 600 Index.
Something to consider: PSCF allocates over 42% of its weight to stocks designated as small-cap value names. That’s relevant because small-cap value is, historically, a rewarding combination, but even more so when dividend yields between that segment and large caps drift apart. PSCF yields nearly three times as the S&P 500.
VanEck Vectors BDC Income ETF (BIZD)
Expense ratio: 9.62% per year
No need to do a double take on that expense ratio because it is what’s listed on the issuer on the site, but the VanEck Vectors BDC Income ETF has some perks, including a 30-day SEC yield of 14.03%. That’s a source of allure at a time when Treasuries offer up puny yields. Plus, like a bond, BIZD delivers monthly payouts.
Business development companies (BDCs) loan capital to financially distressed companies, typically smaller and midsized firms. That underscores some of the risk associated with BIZD in the current market environment as some BDCs themselves are grappling with reduced access to capital coupled with the specter of rising default rates among borrowers.
BDCs are dealing with another headwind: many of the companies they lend to are issuing shares to raise additional capital, thereby diluting BDCs’ equity in the borrowers.
Like any other high-yield asset class, BDCs, as noted above, deal with default risk, but many BDCs issue loans that are higher up in the pecking in the order should the borrower declare bankruptcy, meaning the lending BDC has claim to some compensation above junior lenders.
Investors willing to wait for default waits to trend lower could be rewarded with upside in BIZD and they’ll compensated for their patience with an alternative source of income.
Todd Shriber has been an InvestorPlace contributor since 2014. He owns shares of XLF and SQ.