Broker-Dealers: The Best Financial ETFs?

by on April 29, 2010

The much maligned financial industry has definitely seen its share of ups and downs over the past two years, as a mortgage meltdown, bailouts, Congressional hearings, and rage from Main Street have battered an industry that once seemed indestructible. Despite the ill will towards Goldman Sachs, many financial firms have put this dark period behind them, as banks both large and small have posted estimate-beating earnings and revenues and continued to claw back ground lost since late 2008. These bullish reports have caused financial ETFs to surge as of late; the iShares Dow Jones US Regional Bank Fund (IAT) and SPDR KBW Bank ETF (KBE) have seen their shares soar by close to 25% this year as calm finally began to return to the banking sector (also see Financial ETFs: Seven Ways To Play).

However, some financial ETFs have lagged behind, including those that focus on broker-dealers and exchange operators. These funds generally contain names such as Morgan Stanley, State Street Corp and the CME group, the owner and operator of the Chicago Board of Trade and the Chicago Mercantile Exchange. ETFs that are tracking companies like these are up less than 5% on average thus far in 2010, lagging far behind many ETFs in our Financial Equities ETFdb Category. However, this could be good news for investors seeking to invest in the financial industry but worried about getting in after a big run-up. Besides the appeal as a contrarian investment, the broker-dealer sector has two very important aspects which could offer investors compelling reasons to consider these funds as potential addition to a portfolio.

High Switching Costs For Brokers

Once an investor sets up an account with a broker and builds up a history with them, it is very difficult to switch to someone else; it is a pain to fill out all the paperwork, move all of the securities, and then build up the same relationship with someone new. This works to the brokers advantage since many times they are able to keep a client for life. Furthermore, consolidation in the industry has further limited investors options and made it much easier for companies to keep clients. This reality of the market works to the brokers’ benefit allowing them to maintain robust customer networks that can be relied upon to stay with the company for the long term (for other long-term picks, see Five ETFs For Your IRA).

Near Monopoly For Dealers/Exchanges

If a company wants to list its securities in the U.S. it basically has two options; list with the NYSE (or its subsidiary AMEX) or with the NASDAQ. In some European countries this is even more limited as companies only have one exchange to list on. This near monopoly can create extensive advantages for all of the exchange operators since they do not have to deal with ferocious competition like many regional banks and international banks do. Furthermore, due to their incredible size and the effect of their robust networks, it will be very hard to unseat these firms from their throne atop their respective markets. For example, the CME group, which is a large component of many of the broker-dealer funds, controls 97% of the Treasury futures market and 95% of domestically traded stock index futures. With strangleholds like this, it seems likely that the exchanges will be able to keep the competition at bay for the foreseeable future.

ETF Options

Currently there are three options available to investors seeking direct exposure to this segment of the financial market; iShares Dow Jones U.S. Broker-Dealers Index Fund (IAI), SPDR KBW Capital Markets ETF (KCE), and Claymore/Clear Global Exchanges Brokers & Asset Managers ETF (EXB). Although each of the funds target the same general market, there are a few key differences to be aware of before deciding which one may best suit your needs.

IAI: This fund is relatively concentrated, holding only 26 firms. IAI allocates roughly one-third of its assets to both large cap firms and mid cap securities with the remaining third spread out over small and giant cap securities. Its top holdings include Goldman Sachs (10.35%) and Morgan Stanley (8.4%). See more IAI fundamentals here.

KCE: Much like IAI, KCE is very concentrated holding just 25 securities, all of which are based in the U.S. The firm’s top holdings include Morgan Stanley (8.3%), State Street Corp (8%), and Goldman Sachs (7.7%). The fund allocates 41.2% to large cap securities and 36.6% to mid caps. See charts of KCE here.

EXB: Unlike the other two funds in this market segment, EXB offers investors extensive exposure to international stocks (35.8%). Among its top country holdings include 10.3% to Japan and 4.6% to Hong Kong and the United Kingdom. Its top holdings include Bank of New York Mellon Corporation (5.6%) and Charles Schwab (5.3%). See technical analysis of EXB here.

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Disclosure: No positions at time of writing