US and European bank ETFs present buying opportunity, says Source

Aug 4th, 2015 | By | Category: Equities

The multi-asset research team at Source, one of Europe’s largest providers of exchange-traded funds, has published sector research suggesting that US and European bank ETFs present a buying opportunity. Improving economic condit

US and European bank ETFs present buying opportunity, says Source

US and European bank ETFs present a buying opportunity, according to sector research from Source.

ions, a robust housing market and a steepening yield curve are offered as the main driving forces behind their assessment.

Paul Jackson, Head of Multi-Asset Research at Source, said: “We remain fully committed to financial on both sides of the Atlantic and we are overweight all subsectors, including banks, financial services, insurance and real estate.”

He added: “In our view, valuations of banks are cheap when put in an historical context, although they may be considered to have been in a bubble for 10 years of that history. Profitability remains a problem, with limited loan growth, poor markets and regular dilution from stock issuance; hence return on equity is unlikely to return to pre-crisis levels. But a combination of good valuations, improving economic fundamentals, rising interest rates and a high beta in a rising market means banks, in our view, are a compelling buy.”

One of the key reasons supporting the buy conviction is the steepening of the Treasury yield curve over the past few months which enhances profits for banks by increasing the spread at which they borrow and lend funds. Continued economic recovery in the US has shifted longer-term inflation expectations, increasing yields at the longer end of the maturity curve. Ongoing quantitative easing in the European Union and Japan have also been a factor.

Improvements in the economy also signal that banks are likely to continue expanding their balance sheets, precisely at the moment when it is increasingly profitable for them to do so. A reduction in unemployment, especially in the US where the rate has fallen from 9.6% in October 2010 to 5.3%, coupled with a rise in consumer confidence, should precipitate banks to continue expanding their balance sheets.

Specifically, commercial loans will increase as businesses expand and demand for credit card loans will rise to fund extra consumption. Some major components of the SPDR S&P US Financials Select Sector UCITS ETF (SXLF LN) have significant credit card loan exposures that will likely increase. These include holdings in Wells Fargo (8.7%), JP Morgan (8.2%), Citigroup (5.7%) and Capital One (1.4%).

Banking ETFs have been further boosted through a recovery in house prices. The iShares STOXX Europe 600 Real Estate UCITS ETF (EXI5), which acts as a proxy for the property sector in Europe, is up 18.8% year-to-date. Loan-to-value and debt-to-income ratios, two vital metrics used to gauge the health of the mortgage sector, are also seeing improvements due to rising real estate values, lowered unemployment and higher wages.  Home equity loans, which took a sharp tumble after 2008, are also poised to rise again.

While the housing market continues to expand and banks swell their balance sheets, the adoption of tighter regulations should allay investors’ fears of future bubble formation. Reforms such as Basel 3 and the Dodd-Frank Act have better equipped the financial institutions to manage liquidity and reduce systemic risk.

Further supporting the case for a long position in financial ETFs are the fundamental indicators of bank stocks, having improved on both sides of the Atlantic. Return on equity is up with current levels of 3.4% and 8.0% reported for European and American banking stocks respectively. Price-to-book ratios, a commonly used metric for financial stocks due to assets being consistently marked-to-market, have normalised in recent years and are trading around 1x.

Another metric gauging the health of financial institutions, allowances for loan and lease losses, for all US commercial banks have been revised lower since 2010. The ratio of allowances to total loans was above 3% in early 2010 but has receded to 1.3%, presenting an positive perception on the general quality of bank assets. Delinquency rates (the number of loans in arrears for 30 days or more) as well as number of charge-offs have both improved.

Investors looking for exposure to these sectors have various tools available to them, including ETFs from Source and iShares among others.

One such fund is the Source STOXX Europe 600 Optimised Banks UCITS ETF (X7PS), which tracks a broad range of European banks while excluding those domiciled in Greece and Iceland. Top country exposures are currently the UK (20.9%), Spain (18.5%), France (11.9%), Switzerland (11.5%) and Italy (11.3%). Top firm exposures currently include Banco Santander (9.1%), HSBC (7.1%), UBS (6.6%), BNP Paribas (6.2%) and ING Groep (5.9%). The total expense ratio is 0.30%.

For US exposure, investors could consider the Source Financials S&P US Select Sector UCITS ETF (XLFQ), which tracks the performance of major US financial services firms within the blue chip S&P 500 Index, such as Wells Fargo (8.7%), Berkshire Hathaway (8.3%), JP Morgan (8.2%), Bank of America (6.1%) and Citigroup (5.7%). The total expense ratio is 0.30%. (SSGA also offers a fund, the SPDR S&P US Financials Select Sector UCITS ETF (SXLF), providing the same underlying exposure.)

Other potential funds include the iShares STOXX Europe 600 Banks UCITS ETF (EXV1), the iShares STOXX Europe 600 Insurance UCITS ETF (EXH5) and the iShares STOXX Europe 600 Financial Services UCITS ETF (EXH2), all of which charge management fees of 0.46% each.

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