Oh, financials, financials, financials. Here we go again. JPMorgan Chase reports quarterly profits on Wednesday; Citi announces a quarterly loss on Thursday, Bank of America delivers its results (no one knows if loss or profit) on Friday. The parade will continue right through Halloween.
Cumberland does not use single stocks in its US equity account management. So while we are keenly focused on these reports, we’ll review some of the applicable ETFs instead.
Since March 9 the big bank ETF that tracks the KBW Bank Index has delivered a total return of 145%. The three banks reporting this week constitute 25% of the weight of the exchange-traded fund (ETF) that mirrors that index. Its symbol is KBE. These big banks are deemed “too big to fail” and have benefitted greatly by obtaining the federal government’s direct support and guarantees. That subsidy will be revealed in their positive surprises to earnings reports
Contrast KBE with KRE. It is the exchange-traded fund composed of regional banks that have not been deemed “too big to fail” by the Washington-based troika of Treasury, Fed, and White House/Congress. Many regional banks are small enough to be resolved by the FDIC, and many suffer from a greater concentration of deteriorating commercial loans than their larger brethren. Their status is reflected in the performance of their stocks. KRE has had a total return of only 49% since March 9. It has actually lagged the performance of the S&P 500 index, represented by the “Spider.” SPY has had a total return since March 9 of 59%.
Other broad-based ETFs that hold the three large banks include XLF. It is the widely followed exchange-traded fund composed of the financial stocks in the Standard & Poor’s 500 financial-sector index. XLF’s total return since March 9 is 146%. The three reporting banks make up 27% of the weight.
Contrast XLF with IYF; this ETF tracks the Dow Jones financial-sector index. The three banks are 22% of the weight. Since March 9, IYF has delivered a total return of 122%. Clearly, the heavier the weight of the “too big to fail” banks, the better the ETF has done. Markets are very rational here. They like subsidized businesses that are not going to fail. There’s nothing better in the short term than a government guaranteed profit. Markets ignore the long-term negative implications of the government bailout policy; that will come into focus down the road.
For all the attention given to the banks, the real sleeper in the financial group has been the insurers. KIE is the exchange-traded fund that tracks the insurance index. MetLife, Chubb, Travelers, and Aflac are the four largest weights and constitute 27%. These are not on the government’s “too big to fail” list of 19 firms. They suffered with all insurance stocks in the post Lehman-AIG market cascade last year. They have outperformed the banks on the way back. KIE has a total return of 153% since March 9.
We also need to comment on KCE. It is the ETF that comprises the capital market firms. Lehman was once a prominent member. Goldman Sachs is now the largest weight at 10%. Other large weights include State Street Bank, Morgan Stanley, and Charles Schwab. KCE has a total return since March 9 of 107%.
Since October 1, KIE has been the leader among the specialty financial index ETFs. KCE is second, KBE is third, and KRE is lagging in fourth place. All are up. At Cumberland we have been repositioning the financial sector for several months. Our two overweight financial ETFs are KIE and KCE.
Our rationale is simple. Insurers have a long way to go and were unduly hurt when AIG imploded. That created a buying opportunity. We have recently positioned KCE and expect it to do well; we replaced KBE with it. In a capital-constrained world, the firms that can provide capital to those who need it have very welcome market skills; they will profit. We expect KCE to be an outperforming ETF.
It will be an interesting week as the three banks start the season of financial reporting. As for us, these two ETFs of insurance and capital-market firms represent our choices.
One last note is offered to those who are playing with leveraged financials like FAS. There are costs involved in using this leverage, and there are tracking-error issues. Think of yourself as trading in a margin account with high leverage and imperfect execution. Then act accordingly and with your eyes wide open.
David R. Kotok, Chairman and Chief Investment Officer, email: david.kotok@cumber.com
