As investors have come to grips with the fact that it is highly likely that the Federal Reserve will finally raise interest rates next month, 10-year Treasury yields have begun pricing in that view by soaring nearly 8.5 percent over the past month.
Although financial services stocks, on a historical basis, have questionable reactions to increases in borrowing costs, conventional wisdom holds that the sector is positively correlated to higher interest rates. The corresponding exchange traded funds are reflecting that thesis as the Financial Select Sector SPDR (NYSE:XLF), the largest financial services ETF, is higher by 2.1 percent over the past month.
With rising rates right around the corner (maybe), investors might want to have a look at a new financial services ETF, the Financial Services Select Sector SPDR (NYSE:XLFS). The Financial Services Select Sector SPDR, which debuted last month, was brought to market ahead of real estate becoming the 11th Global Industry Classification Standard (GICS) sector. That change is scheduled to occur after markets close on August 31, 2016. In November 2014, S&P Dow Jones Indices and MSCI, two of the largest providers of indices for use with ETFs, announced real estate previously included as part of the financial services group would become its own sector.
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Another way of looking at XLFS is that the new ETF is XLF without real estate stocks, an important feature when considering real estate equities are vulnerable to rising interest rates and currently richly valued relative to the broader market.
According to AltaVista Research data, the Real Estate Select Sector SPDR Fund (NYSE:XLRE), which debuted with XLFS, has an estimated 2015 price-to-earnings ratio of 36.4 compared to 17.8 for the S&P 500. Underscoring how much of a difference real estate exposure makes in terms of valuation, the P/Es for XLFS and XLF are 12.9 and 14.4, respectively. Remember, XLFS does not hold real estate stocks, but XLF does.
Financial Services firms have made steady improvements in profitability (margins and ROE) since the Financial Crisis, and with lower leverage hopefully they will be more stable as well. Given the robust, double-digit long-term EPS growth projections and reasonable valuation multiples, the sector looks attractive at these levels, said AltaVista.
The research firm rates XLFS neutral. Warren Buffett's Berkshire Hathaway Inc. (NYSE:BRK-B) and Wells Fargo & Co. (NYSE:WFC) combine for over 20 percent of XLFS's weight. Other top 10 holdings include Bank of America Corp. (NYSE:BAC) and Citigroup Inc. (NYSE:C).
Disclosure: The author owns shares of XLF.
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