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Summary The financial sector is the second largest component of S&P 500. Its performance to a large extent is a combination of long equities and short bonds. XLF’s performance clearly illustrates the diversification benefit an investor achieves as opposed to individual stock investment. With a 16.5% share, financial sector stocks currently account for the second largest part of S&P 500, trailing only behind the information technology sector. According to ETFdb , there are 41 ETFs tracking U.S. financial stocks. By far the largest of them is the Financial Select Sector SPDR ETF (NYSEARCA: XLF ), which has $18.5 billion of assets under management (AUM), exceeding the total number for the remaining 40 funds combined. In this article I would like to probe the main contributors to XLF returns, splitting them into two categories. The first one contains broad market forces, or so called factors, driving the ETF’s performance. The second category includes the largest individual holdings, which set the tone for overall funds performance. Factor analysis Analyzing daily price changes from the last 12 months, the simple factor analysis on risk analysis tool InvestSpy gives the first insight into the driving forces behind XLF returns. Using asset classes as explanatory variables, the results table looks as follows: The practical interpretation of this output is that to replicate performance of $1,000 invested in XLF as closely as possible, an investor would need to buy $1,000 of the Vanguard Total Stock Market ETF (NYSEARCA: VTI ), whilst shorting $580 of the Vanguard Total Bond Market ETF (NYSEARCA: BND ), $80 of the SPDR Gold Trust ETF (NYSEARCA: GLD ) and $10 of the United States Oil Fund (NYSEARCA: USO ). The important takeaway is that essentially XLF acts as a combination of long equities and short fixed income. The coefficients estimated by this basic factor analysis enable one to project potential performance of XLF in various market scenarios, incorporating views about stock and bond markets. Largest holdings XLF has 87 holdings, which range from banks to insurance companies to real estate investment trusts. Whilst 82 of these positions have a weight below 3%, each of the largest 5 holdings accounts for more than 5%. This means that 37% of the AUM is invested in only 5 stocks, naturally making them the primary drivers of the fund’s returns. Wells Fargo & Company (NYSE: WFC ) – 8.7% weight Berkshire Hathaway Inc. Class B (NYSE: BRK.B ) – 8.4% JPMorgan Chase & Co. (NYSE: JPM ) – 8.2% Bank of America Corporation (NYSE: BAC ) – 6.1% Citigroup Inc. (NYSE: C ) – 5.4% Over the last 12 months, these five stocks contributed 0.70% to XLF total return of 1.2%. Four out of five largest holdings are banking stocks, which, upon further inspection, demonstrate fairly similar risk characteristics: Source: InvestSpy All four banking stocks have a beta coefficient above 1, showing higher than average sensitivity to the broad market movements. Their annualized volatility ranging from 19.2% to 24.8% substantially exceeds that of the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ), which stood at 15.0% over the same period. BRK.B is a bit of an outlier here and exhibits more contained risk parameters, largely due to the fact that it is to a certain extent a funds in its own right, heavily tilted towards value stocks. Further analysis of the correlation matrix reveals that the same BRK.B is the position that is most correlated to the S&P 500 index with a coefficient of 0.87. Comparing with other top holdings, BAC appears to be the position that is most independent. Source: InvestSpy One observation from both tables in this section is that XLF demonstrates two main features of a pool of individual stocks. First, it has lower annualized volatility and maximum drawdown than its individual holdings, which is a great illustration of the diversification effect. Second, it is significantly more correlated to the broader stock market than its individual holdings as the idiosyncratic risk becomes reduced in a portfolio. Conclusion Putting all pieces together, XLF tends to behave as a combination of long stocks and short bonds. The performance of the financial sector can be projected incorporating investor’s outlook for both of these markets. Furthermore, 37% of the fund is concentrated in 5 mega cap stocks, four of which are banks. Whilst these stocks individually are more volatile than the broad market, putting them together in one basket reduces volatility, beta and drawdown metrics. Unless an investor has a strong preference for a specific financial stock, XLF performance brings all the benefits that one may expect from a sector ETF. Scalper1 News
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