Back a US financials ETF before the rate hike hits

Sector exchange-traded funds (ETFs) are a higher-risk play than their broader counterparts due to their concentration and the fact that they are not always in fashion. But sometimes market movements offer a clear opportunity to make money from a shorter-term trade. Source Financials S&P US Select Sector UCITS ETF is a way of backing the boon handed to banks in the event of rising interest rates in 2016. With a low ongoing charge of 0.30 per cent and decent market cap of $785.2m (£522.7m), it is also a low-cost and liquid way of investing.

Banks have been feeling the pain in recent years, hit by heavy fines for misconduct and told to hold more capital in reserve to prevent another crisis like the 2008 worldwide banking crash.

But the financials sector should benefit from much-anticipated rising interest rates in the US. Higher rates are bad news for borrowers, for whom the cost of debt increases, which is exactly why they prove a boon to banks. US banks have a heavy domestic focus and are able to push a rate hike on to borrowers quickly, earning much more from the deposits on their books than during periods of record low rates.

According to a Source report, US financials have outperformed in previous rate hike periods by a median 5 per cent annualised and did so in 71 per cent of cases - in five out of seven cycles. Banks are also the third cheapest sector in the US.

Shaun Port, chief investment officer at Nutmeg, says regional lending and deposit-focused US banks such as Wells Fargo (US:WFC) will benefit most over more international, diversified banks. He also warns that, while banks do tend to benefit, this could be priced in to markets already. "The key point is that the quality of assets matters more," he says. "There has been a lot of press on this, so there's a strong chance this has been priced in for some time."

There are two main choices, according to brokers and analysts for buying US banks. Source Financials S&P US Select Sector UCITS ETF - our preferred product - tracks the S&P Select Sector Capped 20% Financials index. It tracks 88 financial stocks from the S&P 500 index, but caps each holding so no stock has a weight of more than 20 per cent in the index. It is likely to be more favourable for UK investors as it is listed in sterling on the London Stock Exchange, compared with SPDR S&P US Financials Select (SXLF), which tracks the (uncapped) S&P Financials Select Sector Index but is listed in dollars.

SPDR's ETF is a physical ETF, and cheaper than Source, at 0.15 per cent. However, its small size means that you could end up paying more in trading costs.

The largest holding in Source's ETF is Berkshire Hathaway (US:BRK) followed by Wells Fargo, JPMorgan Chase and Co (US:JPM) and Bank of America Corp (US:BAC). US Bancorp (US:USB) and American Express (US:AXP) also feature in the index's top 10 constituents. Regional banks account for 5.6 per cent of the ETF's holdings. Since inception the ETF has delivered minimal tracking error and tracking difference, in part due to its liquidity.

Source Financials S&P US Select Sector UCITS ETF is available to buy on platforms including Hargreaves Lansdown. However, be aware that brokers often only list the first version of an ETF registered on their platform even though they do offer it in multiple currencies. Make sure you check the ticker and ask for the GBP share class.

There are still plenty of risks facing the banking sector, not least the spectre of further regulation and requirement for banks to hold more capital on their books. But if you want a clear way to play one of the most talked-about events on the global economic calendar, look no further. Buy.

Discrete annual calendar returns (% total return) in GBP

Top 10 holdings

Sub-sector exposure

Source: Source ETF as at 17 November 2015.