ETF Trends
ETF Trends

Financial stocks and sector-related exchange traded funds have finally been able to pull ahead after years of underperforming the broader equities market, but how much further can they go?

Over the past year, the Fidelity MSCI Financials Index ETF (NYSEArca: FNCL) gained 42.3%, Financial Select Sector SPDR (NYSEArca: XLF) rose 42.1%, iShares U.S. Financials ETF (NYSEArca: IYF) added 32.5% and Vanguard Financials ETF (NYSEArca: VFH) was up 42.4%. In contrast, the S&P 500 index was 21.7% higher over the past year.

Meanwhile, the iShares U.S. Regional Banks ETF (NYSEArca: IAT) advanced 52.4%, SPDR S&P Regional Banking ETF (NYSEArca: KRE) jumped 54.9%, PowerShares KBW Regional Bank Portfolio (NYSEArca: KBWR) surged 47.2% and SPDR S&P Bank ETF (NYSEArca: KBE) increased 51.8%.

“As a cyclical, value sector, and arguably the only one that can directly benefit from rising interest rates, financials should be performing well. This case for financials becomes stronger if you assume some dialing back in financial regulation as the Trump administration promises,” Russ Koesterich, Portfolio Manager for BlackRock’s Global Allocation Team, said in a note.

The sector has benefited from the build up of enthusiasm and optimism over the economic outlook, but some traders may be worried about the higher valuations after the recent run up in the sector – Koesterich pointed out that the price-to-book on the sector is up over 40% from last summer’s lows.

Nevertheless, financial sector valuations still look relatively cheap, compared to the broader market. The sector’s valuations are still about 25% below the average since the early 1990s.

For example, IYF is now trading at a 17.4 price-to-earnings and a 1.5 P/B, whereas the S&P 500 index shows a 18.7 P/E and a 2.7 P/B.

“Valuations look less pricey relative to the broader market, which may say more about extended U.S. stocks than cheap banks. Large cap banks are trading at a 60% discount to the broader market. This looks very reasonable against a 25-year horizon, during which the average discount was only around 40%,” Koesterich said.

However, the BlackRock analyst warned that the return-on-assets for large cap banks has declined since the start of 2011, with the ROA now averaging around 0.95%, compared to an average of 1.20% in 2006.

Koesterich attributes the lower returns to stringent regulations and the prolonged low-rate environment following the financial depression, which has suppressed net interest margins. Consequently, investors should expect that a tighter monetary policy out of the Federal Reserve and potential rollbacks on depression-era regulations, notably Dodd-Frank, could fuel growth in the financial sector.

“In order to not be disappointed, investors are going to need to see both higher rates and a lighter regulatory touch,” Koesterich added.

For more information on the financial sector, visit our financial category.