Making the most of turbulent times

Financials led the global economy into the downturn only to rebound strongly this year. But Emma Cusworth finds it is still unlikely to be smooth sailing

Few sectors have seen as much turbulence as financials during the last year. Since 1 September 2008, the Dow Jones STOXX 600 Banks index, for example, has returned -28%. Year-to-date, however, it is up 46%.

Faced with a tougher credit environment and significantly higher single-stock risk among financials, ETFs have increasingly been adopted as trading tools for making sector bets. With further bad news expected from banks in particular, however, short ETFs looked particularly well positioned for future growth.

According to global fund flow data from EPFR Global, who track European financial sector funds with approximately $3.4bn (€2.4bn) in total assets, ETFs represent about a third ($1.1bn) of assets. While all sector funds have seen net outflows year-to-date of $60m, ETFs have received very modest inflows of $7.8m.

Trading volumes show a different story, however. The Financial Select Sector SPDR is among the most traded stocks on the NYSE, with an average daily trading volume for the past three months of 146.8 million shares, representing over $1.5bn.

“Volumes continue to be significantly above historical levels after hitting highs during the financial crisis,” according to Reid Steadman, head of global ETFs at Standard & Poors. “During the course of 2008, $9.7bn of new money flowed into the Financial Select Sector SPDR, despite the index falling 55%. It is likely some of this money came from overseas investors.”

The European view

In Europe, db x-trackers’ DJ STOXX 600 Banks ETF has seen nearly 140% asset growth in 2009, to €166m from €70m in December 2008. “This was helped by the sector performance,” says Manooj Mistry, head of db x-trackers UK, “but investors are also increasingly recognising ETFs as a trading tool for implementing tactical asset allocation views, particularly those unable to use futures and derivatives.”

Claus Hein, executive director of ETF sales at Lyxor, agreed, arguing many institutions and private banks traditionally traded sectors using swaps. “Given the credit environment, a lot of business that was previously conducted through derivatives and other structured vehicles have migrated to ETFs as their transparency, liquidity and tradeability has really come through.”

Furthermore, he argued, secondary market data alone did not reveal their full popularity as a big proportion of daily trading is conducted over-the-counter. In Europe, activity is often not reported as there is no regulatory requirement for brokers to ‘print’ trades and would usually incur fees for doing so. The European secondary market is also fragmented due to multiple exchange listings across countries for any given ETF, further obscuring the liquidity picture.

Total cumulative historical volumes reported for the last three months of 2008 for Lyxor’s ETF DJ STOXX 600 Banks, which is available on Euronext, Deutsche Boerse, Borsa Italiana and Bolsa de Madrid, was approximately €270mn. In contrast, gross primary market activity in the fund, or total fund creations and redemptions, for the same period was €1.2bn.

This overall figure better demonstrates the extent to which investors have been actively using the Banks ETF to trade in and out of the sector, Hein argued.

Driving force

In no small part, demand has been driven by a greater need for diversification. During the past year, spectacular banking failures have dramatically increased the risks of holding single stocks, which has been reinforced by mixed trading results in recent months.

According to Steadman, many investors had previously been content to hold a small number of large, representative names, but diversification was now the priority. “Some financial sectors might be down as much as 50% to 60%,” he said, “but that is better for investors than holding individual stocks that fell to zero, like Lehmans. The need to diversify has increased and financial sector ETFs are a ready-made solution.”

Even in the more stable environment, ETFs offered a better option, according to Ralph Stemper, product manager in equity markets and commodities at Commerzbank. “Some financial companies have delivered good results, but some have not, so buying the sector diminishes risk and reduces the amount of research needed into individual companies. 

“We have also seen a move by customers towards easy-to-understand, transparent vehicles and away from structured products in the months since Lehmans collapsed,” he added.

By using financial sector ETFs, investors were also able to take greater advantage of their research through pair trading. As Mistry explained: “An investor might have one or two favourites and could therefore go long those stocks and short the sector using an inverse ETF.”

Short (or inverse) financial ETFs have been rapidly gaining momentum, as the db x-trackers DJ STOXX 600 Banks Short ETF demonstrated. After a dormant period during the shorting bans of 2008, the fund has seen significant inflows. Having started 2009 with €25m, assets now exceeded €200m, outstripping its long counterpart by €34m.

“We are seeing anecdotal evidence that investors are taking a bearish view on the financial sector and are positioning themselves for a fall,” Mistry said. Furthermore, he added, assets in the insurance sub-sector ETF had remained stable, suggesting investors were focussing on banks to determine the direction of the financial sector.

A grim future?

Investment industry experts have voiced concerns about the banking outlook in recent weeks, despite better than expected results from some of Europe’s biggest players, including Barclays and HSBC.

Phil Collins, manager of the Newton Phoenix Multi-Asset fund, believed further loses, capital raisings and lower profitability were likely, making banks unattractive. Political actions to date allowed them to access funding and stabilise the system, but, he warned, the underlying issue of too much debt remained unresolved. Until debt levels were reduced or defaulted on, the “ominous spectre of further problems remains”.

Dexia Asset Management also argued the short- and long-term outlook was very challenging and the risks were undoubtedly downwards as the default cycle was still beginning and credit losses would continue to increase, not peaking before 2010.

“We have seen big asset flows in short financial ETFs, which are among the most traded,” Steadman added. “New financial sector ETFs will likely focus on this area as investors are driven by a desire to reap positive gains from negative market moves.”

List of financial ETFs