In the first half of 2014, the market performance of the U.S. financial-services sector trailed the broader U.S. equity market by several hundred basis points.
Thus far this year, there have been some small bumps in the road for a sector that has enjoyed a robust comeback during the past five years, but where volatility remains meaningfully high and uncertainty even higher. While no one doubts that large banks, which dominate the financial sector, are far better capitalized than they were heading into the financial crisis, the final results in March of the Federal Reserve's annual stress test on the United States' 30 largest banks demonstrate both a lack of robustness on the part of some large lending institutions--including 
Citigroup C--as well as the clear presence of a prominent headwind in the form of elevated compliance, regulatory and legal costs across the industry.
Another headwind is the U.S. economy. While it unquestionably has shown some bright spots during the past several years, concerns about a less-than-strong economy generally has weighed on banks, which feel less inclined to lend in such an environment. Less lending means less growth for banks.
The opportunity in U.S. financial services
Morningstar's equity analysts view the financial-services sector as largely fairly valued, with pockets of opportunity in individual stocks. A future rally in the sector likely would be driven by several factors, including continued improvement in the U.S. economy (and likely, overseas economies as well), which would in turn prompt central banks to continue pulling back on their "easy money" policies and instead allow for interest rates to rise. That likely would mean greater lending from banks, as well as lower global unemployment. At the same time, global markets would need to continue their march upward (Morningstar's equity analysts hold the view that the financial-services industry's asset managers' performance more or less will follow the market). And, in theory, continued strong markets would bring more deal activity for investment banks. On top of all this, banks likely would continue their ongoing cost-cutting efforts (we view many physical bank branches as endangered species).
Unpacking specific subsectors' performance
Broadly, the financial-services sector breaks down into a handful of subsectors, which include banks, insurance firms, REITs and asset managers/capital markets. Banks have underperformed the overall U.S. equity market thus far this year, amid stress-test results and a general sector rotation away from financial services. Insurance firms also have lagged amid strong debt and equity markets, which tend to force down insurers' prices and thus returns on invested capital. Meanwhile, REITs have done very well after a not-so-great 2013, during which investors panicked. Although one might think that the specter of rising rates would hurt REITs, rising rates also usually mean a strong economy, and for REITs, a boom means higher occupancy and steadily increasing rents on tenants.
An overview of market-cap-weighted financial-services ETFs
There are three large and liquid cap-weighted ETFs that target the U.S. financial-services sector: Financial Select Sector SPDR XLF, Vanguard Financials VFH and iShares U.S. Financials IYF. All seek to replicate broad indexes of the largest U.S. financial stocks, including diversified financial-services companies, banks, REITs, insurers and capital markets firms. All have relatively similar portfolios, although there are small differences in composition.
Fidelity recently launched a broad-based, cap-weighted financial-services ETF, Fidelity MSCI Financials Index FNCL, with a rock-bottom expense ratio of 0.12%. Although the fund has had some success gathering assets ($121 million as of this writing), the three larger broad financials ETFs dwarf FNCL in terms of assets and liquidity.
PowerShares S&P SmallCap Financials PSCF is another market-cap-weighted ETF devoted to the financial sector. As its name suggests, PSCF tracks an index of small-cap U.S. financial-services companies. It takes its holdings from the S&P SmallCap 600 Index. In the Morningstar Style Box, PSCF falls within the core-value segment, between micro-cap and small cap. Morningstar does not compute a price/fair value ratio or an Economic Moat Rating for PSCF. The ETF has lagged cap-weighted financial ETFs during the past year, although its performance has been in line with those funds over the past three years. PSCF's expense ratio is 0.50%.
Data points
Valuation-wise, investors could benefit from looking first at price/fair value ratios. One of the most useful data points for ETF investors is Morningstar's fair value estimate, which leverages the bottom-up fundamental analysis produced by our global team of equity research analysts. Our equity analysts evaluate the value of a business using our discounted cash flow model, which calculates the present value of a company's future discretionary cash flows based on its cost of capital, as determined by our analysts. Our per-share fair value estimate represents the aggregate, asset-weighted fair value estimate of the stocks in an ETF's portfolio that are covered by Morningstar equity analysts, divided by the ETF's number of shares outstanding. Our equity analysts may not cover each of the stocks in an ETF's portfolio, so we assume the stocks that aren't under coverage trade at fair value.
Looking at the three market-cap-weighted financial-services ETFs, we see that they all trade at ratios greater than one, which indicates that the portfolio may be overvalued. XLF and IYF both trade at 101% of fair value, and VFH trades at 102%. So the three big cap-weighted financial-services ETFs do not trade at any kind of discounts to their fair values.
When evaluating ETFs, another useful data point is the economic moat rating, which helps establish the quality of a fund's underlying portfolio. Morningstar's equity analysts evaluate firms' competitive advantages, or the barriers that a company builds around itself, as well as how long we believe the company can sustain that edge over its competitors. Our equity analysts spend a great deal of time evaluating and debating the strength and sustainability of a firm's competitive advantage and examining its returns on invested capital before assigning it to one of three moat sizes: wide, narrow or none. Wide-moat companies all tend to have at least one strong sustainable competitive advantage (many have several) and earn ROICs well in excess of their cost of capital. Narrow-moat firms, by contrast, are ones that may not be able to continue generating hefty ROICs as competition heats up over the long haul.
In any sector, there's a broad mix with all kinds of moat sizes. However, a portfolio with a large percentage of companies with narrow and wide moats is one that we would categorize as high-quality. The bulk of the assets in large, market-cap-weighted financial-services ETFs are invested in narrow-moat companies. For example, 19% of XLF's assets are devoted to wide-moat companies and 61% are invested in narrow-moat firms. The ratios are similar for VFH and IYF (see table below). Clearly, the large market-cap-weighted financial services ETFs are fairly high-quality portfolios, although anywhere from 10% to 15% of assets are invested in companies with no competitive advantages whatsoever.
Strategic-beta financial-services ETFs
There are several good-sized ETFs devoted to the financial-services sector that seek to improve their return profile relative to traditional market benchmarks. Morningstar terms this category of funds strategic beta. Here are three strategic-beta ETFs devoted to the financial-services sector that we believe are worth discussing.
The first, Guggenheim S&P 500 Equal Weight Financial RYF, tracks an equal-weighted index of 84 stocks. As is the case with other equally weighted funds, RYF offers more of a small- and mid-cap tilt than its market-cap-weighted peers. For example, 35% of RYF's portfolio consists of mid-cap names, compared with just 9% of XLF and 21% of VFH. RYF is only slightly more volatile than its cap-weighted counterparts. RYF has meaningfully outperformed its cap-weighted brethren over the trailing one-, three- and five-year periods. RYF's position in the style box is almost identical to that of VFH; both funds fall between medium and large and near the boundary of core value and core. RYF also invests in a significant number of high-quality financial firms. In fact, just 18% of RYF is devoted to companies with no economic moat. RYF charges 0.40% and trades at 103% of fair value.
First Trust Financials AlphaDEX FXO tracks a fundamental index that uses a proprietary stock-selection methodology to rank financial firms on both growth and value factors. As a result, FXO's portfolio differs meaningfully from many of its sector-ETF peers. The index rebalances quarterly and takes valuation into account when rebalancing. As a result, FXO sits squarely in the centre of the core-value band in the style box, while the cap-weighted financials ETFs -- and RYF -- all sit at or near the border between core value and core. FXO's portfolio also has more of a small- and mid-cap tilt than its competitors, with fully 57.5% of assets invested in mid-cap firms and another 15.0% devoted to small-cap companies. FXO has meaningfully outperformed the cap-weighted U.S. financials ETFs over one-, three- and five-year periods, and it has done so with slightly less volatility than the cap-weighted funds. FXO charges 0.70%.
Finally, PowerShares KBW High Dividend Yield Financial KBWD is a concentrated, higher-risk but higher-yielding financial industry ETF that tracks a dividend-yield-weighted index containing small- and mid-cap financial firms like banks, insurers and equity and mortgage REITs. In the style box, KBWD is squarely in the deep-value region, between micro-cap and small cap. It has no direct peer. Morningstar's equity analysts don't cover enough of its holdings for us to have an estimate of fair value for the fund or a moat rating. And the fund only has traded for about three and a half years, so it has less performance history than some other financials ETFs. However, KBWD has meaningfully lagged its traditional cap-weighted peers over one and three years. The ETF yields about 8% but charges a pricey 1.55%.
Sub-sector-level financial-services ETFs
Investors with a strong conviction about an individual subsector within U.S. financial services can consider ETFs devoted to banks, REITs or insurers. Banking firms have lagged the U.S. financials sector thus far this year in the wake of the mixed results from the stress tests. BMO Equal Weight U.S. Banks Index is the only TSX-listed ETF targeting U.S. banks and comes in currency-hedged ZUB and unhedged ZBK versions, both of which charge management fees of 0.35%. The largest and most liquid broad-based banking ETF in the U.S. is SPDR S&P Bank KBE, which charges 0.35%. Investors interested solely in regional banks can consider SPDR S&P Regional Banking KRE (0.35%), iShares U.S. Regional Banks IAT (0.46%) or PowerShares KBW Regional Banking KBWR (0.35%).
REITs in the U.S. have performed very well thus far in 2014, enjoying a recovery after investors panicked in 2013. The market for REITs came back after investors acclimated to the notion of the Fed potentially winding down quantitative easing. And investors' bullishness comes from the signaling effect that would be inherent in higher interest rates--namely, that rates tend to rise when an economy is strong. REITs are cyclical by nature, and with a boom would come higher occupancies and the ability for REITs to steadily increase building rents. Investors interested in REIT ETFs should consider Vanguard REIT VNQ (0.10% expense ratio), Schwab US REIT SCHH (0.07%), iShares U.S. Real Estate IYR (0.44%) and iShares Cohen & Steers REIT ICF (0.35%).
