Time to buy a financial sector ETF?

A bet on banks is undoubtedly contrarian but many commentators say the global financials market is on the turn and several ETFs give exposure to financial companies across the world for a reasonable price tag.

David Liddell, director of online investment advice firm Ipso Facto Investor, says: "Quite a few of the big banks are trading below book value and, compared with the last 20 years, they look cheap. The other big story is financial stocks' ability to start paying dividends again."

Financial shares used to be very popular for their distributions but these dried up following the financial crisis. Lloyds Banking (LLOY) announced in February that it would pay out its first dividend to shareholders since the financial crisis in February. It also posted an £1.8bn pre-tax profit for the last financial year, up from £415m in 2013.

Adam Laird, passive investment manager at Hargreaves Lansdown, says: "The banks have come under scrutiny and have done a lot to shore up their balance sheets. They're looking more financially stable and that's been emphasised by the stress tests going on in the US and Europe.

"We're in a good position where funding is still very cheap, so the banks have easier access to money to be able to make loans."

When investing in financials, the key is to broaden your coverage to spread risk. The eurozone banking sector is still in a very different state of health to the US market, with US banks soaring ahead of their European counterparts on investment banking profits.

With a UK election in which a tough line on banking could form a central point and several fines still rumbling on, the financial sector could be a nail-biting place to invest.

"Fine escalation is an issue," says Mr Liddell. "Neil Woodford raised it in quite a high-profile fashion when he first bought into HSBC and then sold out of it on the basis that fines would escalate (in September 2014) and there seems to be no end to the allegations but at some point soon we must have gone through every aspect of these banks."

Mr Laird says: "I wouldn't say that the regulatory risks are over. We are still seeing fresh fines being levied against banks and more institutions are being caught up in the Libor and forex scandals."

It is also important to consider access to multiple parts of the financials sector, including asset managers as well as banks. Mr Laird says: "Some products just look at the banking sector and others cover all financial companies, including insurers, asset managers and other financially involved companies. Although they are strictly banks people forget that payment companies such as American Express are an important part of that market."

Three products to consider

Mr Laird recommends ETFs that track the MSCI World Financials Index. This index is made up of large- and mid-cap financial companies across 23 countries, with the US making up the majority of exposure, at 44 per cent. The top 10 constituents include US investment banks Wells Fargo and JPMorgan Chase & Co as well as HSBC and Citigroup, but the index is also exposed to insurers, which make up 20 per cent of the index, and real estate investment trusts, at 11 per cent.

He says: "I'd suggest Amundi ETF MSCI World Financials (CWF), which has a total expense ratio (TER) of 0.35 per cent, as the charge is slightly lower and performance slightly better."

Since launch, the fund has closely tracked the index. With the exception of a fall in returns of 18.13 per cent in 2011, both the index and ETF delivered solid results, with CWF returning 24.71 per cent in 2013 compared with 24.97 per cent for the index and 8.38 per cent in the year to date compared with 8.53 per cent from the index.

Lyxor UCITS ETF MSCI World Financials (FING) has delivered similar results, but has an ongoing charge of 0.4 per cent.

Financials ETFs offering exposure to Europe include Source Stoxx Europe 600 Optimised Banks UCITS ETF (X7PP). This fund provides access to many of the largest and most liquid banking stocks in Europe. It is constrained so that all individual stock weights are capped at 10 per cent, making it less top-heavy than other ETFs tracking European financial services. But it has been highly volatile over the past 10 years, exhibiting annualised volatility of 27 per cent, according to Morningstar, compared with 20 per cent for the wider MSCI Europe index.

Performance (% total returns) of financials ETFs

Source: FE Analytics, as at 13 April 2015