Three Reasons Why The Financial ETF (XLF) Is Soaring

by on March 26, 2010 | ETFs Mentioned:

Financial shares were among the hardest hit during the “Great Recession” that began in late 2008 when many institutions crumbled under the weight of massive debts. The crisis caused many casualties and lead to significant restructuring in the industry, as former foes became partners in a variety of financial niches. Although many financial companies lagged behind the broad market for quite some time, the survivors have made an impressive push in recent months. Bank of America (BAC) is up nearly 600% since its lows a year ago, while J.P. Morgan (JPM) has more than doubled and Wells Fargo (WFC) has tripled in the same period. This amazing run-up has delivered some big gains to investors who managed to spot the true market bottom. After surging in 2009, financial ETFs have continued to rally in 2010, leading some investors to believe that the worst is finally over for the industry and that the sub-prime clouds may have passed for the time being.

While there are many options to play financial ETFs, the most popular is (XLF), which has close to $7 billion in assets under management and trades an average of 100 million shares a day (for other options in the financials sector, see Financial ETFs: Seven Ways To Play). The fund is up over 12% this year and close to 2% this week, leaving XLF with a gain of over 70% in the past 52 weeks. Although the broad market has been surging as of late, financials have led the way higher so far this year. The mini-rally is being driven by a number of factors, but three in particular stand out:

1. Opportunistic Buying

Everyone's Favorite Banker; George BaileyThe Standard & Poor’s 500 Financials Index was at a 17-year low one year ago, allowing any investors who were in it for the long-term to buy in cheaply at prices not seen since the early 90′s. And with the Federal Reserve guaranteeing many bank assets, further downside risk was virtually eliminated.

The freefall of financial stocks in late 2008 was driven by some very real fundamental factors, but fear also played a role in exacerbating losses. The sell-off in financials was greatly exaggerated by investors expecting a complete collapse of the industry. This scenario sent tons of fresh money into the beaten down financial sector which has rebounded back to more realistic levels.

2. Low Loan Losses

According to Dick Bove of Rochdale Securities LLC in an article for BusinessWeek, “Stocks are going to go much higher, the catalyst is the reduction in loan losses. That’s all that investors in banks care about.” Bove claims that the  financial industry has already seen a “bottom” in writedowns from the collapse of the sub-prime mortgage market, suggesting that the worst could be behind the troubled industry. If this turns out to be true, financial shares could quadruple over the next two to three years according to Bove, a scenario that has sent caused bullish investors to further bet on the sector.

3. Prospects Of Higher Dividends

Many bank and financial stocks used to rely on heavy levels of dividends in order to entice investors. While many of these payouts have been reduced or eliminated altogether in recent years, some analysts believe that we could see a return to high-dividend paying financials. “The government at the moment is saying you can’t do it,” Bove said. “These banking companies were at one point in time yield vehicles and they were owned by income funds. The banks are going to get back to being that type of investment.” Furthermore, with record low rates from the Fed, any increases in dividends will make financials even more appealing to income minded investors who are tired of receiving anemic yields on their fixed income investments (see Five Bond ETFs For Yield-Hungry Investors).

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Disclosure: No positions at time of writing