By ETF Heat Map Team
The financial sector, which is the second largest in S&P 500 index, has been experiencing growth given the favorable low interest rate environment. Consider PowerShares KBWB Bank Portfolio ETF, which within the past 3 months has outperformed the S&P 500 on a rate hike expectation. However, as the market cuts probabilities of a September rate hike, this ETF should present a decent entry point for participants expecting a December rate hike scenario. As such, we preview bank ETFs and specifically highlight two of them below:
· KBWB – PowerShares KBW Bank PortfolioETF
· KBE – SPDR S&P Bank ETF
KBWB, PowerShares KBW Bank Portfolio, is an Invesco product that is a market capitalization-weighted index that seeks to reflect the performance of 24 representing leading national money centers and regional banks or thrifts in the US. Its’ top three holdings comprise approximately 25% of the portfolio and include Bank of America, JPMorgan Chase and US Bancorp. It has a 30 day SEC yield of approximately 2% and has an expense ratio of 0.35%.
Given that the low interest rate environment has put downward pressure on the Net Interest Margins (NIM) of all banks, especially the largest ones, ETFs such as KBWB (which is market capitalization-weighted index) should outperform in a rising rate scenario.
Another Bank ETF, KBE, the SPDR S&P Bank ETF, is a State Street product which is considerably more diversified that KBWB (having approximately 65 securities). It has an objective to provide a total return in line with the performance of the S&P Banks Select Industry Index. Its’ top three holdings comprise approximately 7.5% of the portfolio and include Bank of America, Citizens Financial and First Republic Bank. It has a 30 day SEC yield of approximately 1.6%, an expense ratio of 0.35% and a P/B ratio of approximately 1.1x.
The Federal Reserve’s actions to raise or maintain key rates will significantly determine the performance of the financial sector, which will have a significant influence of the performance of these exchange traded funds. The bonds markets are currently setting prices based on a December rate hike as opposed to a September one. This is also a huge blow considering that the financial sector had been entering the year on the expectation of a multiple rate hike scenario.
Nevertheless, as certain key indicators keep gradually improving, the interest rate should increase. The banks (especially ones with a large deposit base) have been looking forward to Fed’s rate hikes to enable them increase the NIMs. This is a key measure for them because it gauges the level of operational profitability. Fed’s target rates directly influence the interest rates charged and this means the income earning potential is relatively instantaneous, while deposit rates are a bit more gradual. The low interest rate environment has put downward pressure on the NIMs of all banks, especially the largest ones, market capitalization-weighted financial ETFs should outperform in a rising rate scenario. The coming weeks might present a decent entry point for a well balanced portfolio tilting towards a rising rate scenario.