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Summary The fund offers a reasonable expense ratio and incorporates more than banks. One of the challenges for investors is the combination of REITs and other stocks in a single ETF. Looking into the REIT holdings, I’d rather not see such a huge focus on the biggest companies. The historical volatility on the fund demonstrates the risk of going so heavy on the sector. Investors should be seeking to improve their risk adjusted returns. I’m a big fan of using ETFs to achieve the risk adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. I’m working on building a new portfolio and I’m going to be analyzing several of the ETFs that I am considering for my personal portfolio. One of the funds that I’m considering is the Financial Select Sector SPDR Fund (NYSEARCA: XLF ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. Index XLF attempts to track the total return (before fees and expenses) of the Financial Select Sector Index. Substantially all of the assets (at least 95%) are invested in funds included in this index. XLF falls under the category of “Financial”. It sounds like the ETF would be very highly concentrated, but it includes everything from diversified financial services to REITs and banks. When I was first reading about the holdings, I was expecting more diversification than I found. You’ll see what I mean when I get to the holdings section. Expense Ratio The expense ratio is .14%. It could be a little better, but it isn’t too bad. Industry The allocation by industry is interesting. Investors that are new to the fund may simply assume that it allocates everything to “financials”, but the fund’s website goes much deeper in explaining which parts of the financial sector is going to get the weights. The allocation to banks is heavy, but it is also well below 100%. The fund also uses heavy allocations to insurance and REITs. I certainly prefer this strategy to going exceptionally heavy on the banking sector, but I find the holdings somewhat problematic as I prefer to run my REIT exposure through tax advantaged accounts. This is a challenge for any ETF that wants the diversification benefits of incorporating REITs. There isn’t much an ETF can do to get around this other than simply not holding REITs. Holdings Since I’m primarily a REIT analyst, the REIT exposure is the first part of the portfolio that my eyes are drawn to. The heaviest REIT allocation here is Simon Property Group (NYSE: SPG ) which I find a little disappointing. I find the REIT sector attractive for investing, but REITs should be divided between types the same way that banks and insurance companies were split up into different sectors. SPG is an absolutely enormous REIT, but I’d rather see exposure to Realty Income Corporation (NYSE: O ) or the fairly new STORE Capital (NYSE: STOR ). I simply prefer triple net lease REITs like O and STOR to most other types of REITs. Realty Income Corporation is included in the portfolio, but it is only .43% of the total portfolio. Since I prefer keeping REIT exposure inside tax advantaged accounts, there was already one challenge with the REIT allocation. I’m not thrilled with the allocation strategy for choosing REITs, which creates another challenge. Return History Historical returns shouldn’t be used to predict future returns, however the historical values for factors like correlation and volatility over a long time period can provide investors with a base line for setting expectations on whether the asset would fit in their portfolio. I ran the returns since January of 2000 through Investspy.com and came up with the following charts: (click to enlarge) Since 2000 the ETF has a total return of about 45% compared to the S&P 500, represented by SPY , having a return of 90.3%. The underperformance isn’t so much of an issue as the risk level. The fund had an annualized volatility of 33% compared to 20% for SPY. There were two market crashes during that period which leads to much higher volatility numbers, but the general premise remains. The fund is substantially more volatile. Since the holdings are also more concentrated, that makes sense. Unfortunately, when we switch to using beta as our measurement of risk the problem remains. The sector allocation simply lends itself to too much volatility for my portfolio. Conclusion XLF is a huge ETF for exposure to the financial sector. There are some bright spots for the fund, but the overall product is a little lacking for my tastes. The combination of other financial sectors with REITs may be acceptable for investors that have plenty of room in their tax advantaged accounts or investors that aren’t concerned with tax planning. Even moving past that, I’m not thrilled with the methodology for selecting REITs as it results in prioritizing enormous REITs. That is an area where I’d rather be adding individual stocks or using REIT specific ETFs with lower expense ratios. Seeing the enormous volatility reinforces my concerns about overweighting this particular sector. The fund may do very well in a continued bull market, but I’d rather keep a more defensive allocation. I just don’t like the risk of facing a third correction before the decade is over. I’ll keep most of my portfolio in equity, but I’ll stick to the more defensive companies and sectors. Scalper1 News
Scalper1 News