Banking on finance

Polarised views on the banking and financial sector have led flows to swing into and out of ETFs tracking this area. Alison Swersky looks at issues causing the split sentiment

 

One could get dizzy keeping track of the weekly inflows and outflows in ETFs based on banks. In the week ending 1 April, investors poured $60.7m into Stoxx 600 banking sector ETFs, according to BlackRock, accounting for the biggest sector inflows that week. 

BlackRock’s ETF Landscape report shows one week later, investors were hauling out their money. In the week to 9 April, $160.2m vanished from such funds, by far the largest net outflows of any sector in that period. Subsequently in the week after that, investors cautiously returned, handing over a net $19.4m.

Historically, this sector of blue chip financial institutions did not attract such wild swings. 

However, in the last few years this sector has become increasingly volatile. 

“Banks have been in the spotlight ever since Bear Stearns teetered on the brink of collapse in 2007,” says Paul Brigandi, senior vice president at ETF provider Direxion. 

He says: “The sub-prime mortgage catastrophe followed, then Lehman Brothers fell and this sparked a real and palpable fear in bank stocks. During this period, bank shares had a higher beta than the overall market.”

Brigandi explains bank shares consequently steamed ahead of the market during the rebound last year. This was largely fuelled by government bail-out programmes, positive earnings reports and low interest rates driving liquidity, making 2009 a tremendous year for the sector. 

In this environment, the Direxion Daily Financial Bull 3x Shares was in the pound seats. 

Designed to deliver three times the daily performance of its benchmark, the US Russell 1000 Financial Services index, the fund notched up an impressive 207.99% over 12 months, far outperforming other ETFs in the same period. It also delivered the best performance over three months, up 36.8%.

The Direxion Daily Financial Bull 3x Shares has been one of the most popular of the issuer’s family of ETFs since its launch in 2008 at the height of the financial crisis, garnering close to one billion dollars under management.

Conversely, the firm’s Daily Financial Bear 3x Shares has been equally popular. The fund does the exact opposite of its twin, as it is designed to deliver three times the daily inverse performance of the same underlying index. 

“This reflects viscerally the polarisation of views on the sector,” says Brigandi. “The bulls are focusing on strong earnings reports from some of the major US banks, including Goldman Sachs, Citigroup and Bank of America, and the strength of the economic recovery.” 

He adds: “The bears, meanwhile, are concerned about the political and regulatory overhang that threatens to rein in profits.”

He points to the Securities and Exchange Commission’s shock fraud charge against Goldman Sachs, which sent the bank’s shares down almost 13% on the day and knocked the Russell Financial index on fears that other Wall Street institutions could be vulnerable to a similar fate.

Furthermore, President Barack Obama’s financial reform bill, which is currently making its way through Congress, will hit certain money making activities, such as derivatives trading, if passed in its current form.

“Whether positive or negative, as long as the sector remains in focus it will continue to attract attention from investors looking for short-term opportunities, on the up or downside,” says Brigandi.  

 

Other causes for concern

Beyond the US, there are continuing concerns about sovereign debt, particularly with regard to Greece’s financial woes. Adverse foreign exchange movements have also been a problem for issuers. These factors have deterred investors to an extent, which in turn has led to outflows from certain funds. 

In the shorter term, the performance of these ETFs has evidently been affected by the declining euro. 

The iShares Eurostoxx Banks fund, for example, was down four percent over three months, and more than nine percent over six months. The fund was up 65.06% over the one-year period. 

Indeed the firm attributes this shorter term performance to the hammering of the euro, as worries have mounted over the financial stability of certain EU economies, particularly Greece, Spain and Portugal.

The broader European ETF iShares Stoxx 600 Banks fund, which invests outside the eurozone in the UK, Switzerland, Sweden and Denmark, also performed better over the one-year period, increasing 70.81%. 

Both ETFs are structured using traditional replication, holding the index constituents. As neither index complies with Ucits rules on investment limitation, the firm created a new fund four years ago using a swap with Unicredit Group that is Ucits III compliant. 

“At the height of the financial crisis, we reduced the counterparty risk on the Stoxx 600 Banks swap-based ETF to five percent from 10% to reassure investors,” says Blanca Koenig, iShares senior sales strategist.

With counterparty risk continuing to be a thorny subject, newcomer to the ETF space Source has found an innovative way to spread the risk for its Stoxx 600 Optimised Banks Source ETF. 

Instead of one counterparty, it has contracts agreed with six major investment banks and the swaps are reset every day.

“For the week ending 16 April, our counterparty exposure was nine basis points, almost negligible” says Source chief executive Ted Hood. 

Source launched 18 sector ETFs last July, with the aim of offering hedge funds, which form one of the most prolific types of ETF investor in the US, affordable products to short. 

According to Hood, currently high borrowing costs to short an index like the Eurostoxx through an ETF mean hedge funds typically use swaps.

“But given the chance many would rather use ETFs, which are much simpler to use and don’t tie the hedge fund into executing a deal with one swap provider,” says Hood.  

He explains Source started with sector ETFs because hedge funds are big traders of sectors, often taking conviction on a stock and then shorting the industry index to strip out market risk and bottle the relative outperformance. 

Hood also believes that sector ETFs are bound to gain in popularity. “It’s so very difficult in a liquid, well-researched market to beat the market with stock selection,” he says.

He adds: “Professional and institutional investors are increasingly taking a view on asset allocation as a way of generating value, rather than trying to bet which two or three firms in the sector will produce results.”

 

 

 

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