Financial sector stocks and exchange traded funds are looking much stronger as we ride the economic recovery. Nevertheless, while muted, many of the old problems that have weighed on the markets still linger.

Morningstar ETF analyst Robert Goldsborough points out that a number of factors are supporting the financial sector, including macroeconomic improvements, lower unemployment rates, increased borrowing and repayment rates, rising financial advisory and equity trading businesses, and improved spreads down the line when interest rates inch higher. [Bank ETFs Look to Reclaim Leadership Role]

Nevertheless, Goldsborough warns of some hurdles to watch.

“But many of the same headwinds facing the sector are unchanged–starting with continued low interest rates (which will remain so for the foreseeable future) and the lower interest-rate-spread revenue that banks have accepted,” Goldsborough said. “Added regulation has meant another layer of costs for financial services companies, and counterparty relationships with European banks could mean losses for U.S. banks if Europe’s banking system collapses.”

The analyst also points out that the financial sector has a high beta exposure – high volatility characteristics – to the U.S. economy. He notes that a number of factors can affect financial stocks, including small changes in unemployment, consumer confidence, housing and even the yield curve.

For those interested in a broad financial sector ETF, Goldsborough suggested taking a look at the Financial Select Sector SPDR (NYSEArca: XLF), which includes commercial banks, diversified services firms, capital markets companies, insurers, REITs and consumer finance firms.

The fund is market-capitalization weighted, so the top ten of its 80 or so holdings make up a little more than 50% of the overall portfolio. Nevertheless, the ETF offers a diversified approach to the sector.

“This ETF offers the diversification that we think is prudent in a sector where some aspects of companies’ operations are so opaque that it can be difficult to gauge their true risk exposure,” Goldsborough added.

Next page: More financial ETF options