XLF - FNCL: A Mini XLF With Similar Momentum

2023-04-20 16:42:48 ET

Summary

• FNCL invests in financial institutions like those focused on banking, insurance, and credit cards.
• This ETF has gained momentum as some banks’ earnings surpassed expectations and investors increasingly regain confidence in the United States banking system.
• FNCL is also still under the threat of an economic downturn, and could be one of the first to face the adverse effects of even a small recession.
• I rate FNCL a Hold, as I believe the mixed market sentiment has many financial investors at a fork in the road, prompting me to take the middle ground.

Investor sentiment in the financial sector is beginning to look up. However, the market is likely still due for some bearish periods before the Fed achieves its 2% inflation target. On this note, I believe a lot of the greed that is beginning to appear in the market is primarily based on speculation, and could age poorly in the short-medium term. In the long-term, I am still bullish on financials and think that they could be some of the first assets to reap the benefits of a healed economy. For these reasons, I rate the Fidelity MSCI Financials Index ETF ( FNCL ) a Hold. I would not be surprised if I came back to upgrade this ETF in the next couple months, but I believe the current market conditions are still quite uncertain and volatile, especially in regards to financials.

Within the next 3-5 years, FNCL could provide investors with generous returns as it houses some of the most profitable and robust entities on Wall Street. This quality makes it similar to the Financial Select Sector SPDR Fund ETF (XLF). For the time being, selling this ETF could induce serious FOMO in the long-term, while the coast is also not clear enough for me to confidently rate FNCL a Buy. As my neutral position stands, I plan to watch this ETF closely in the coming periods.

ETF Profile

Strategy

This ETF tracks the MSCI USA IMI/FINANCIALS 25-50 NR USD Index and employs a representative sampling technique. In doing so, stocks within FNCL presumably share investment characteristics, fundamental characteristics, and liquidity measures with those of the designated index. Each holding's relative weight is determined by their market capitalization, return variability, and yield.

Holdings Analysis

FNCL holds almost exclusively financial stocks with miniscule appearances from real estate as well as industrials. This ETF is limited to solely companies headquartered in the United States. Though FNCL could produce generous profits in the long-term, it is likely not the best choice in regards to sector or geographical diversification.

The top 10 holdings in this ETF account for 43% of the total holdings while the top 25 comprise 63%. FNCL contains almost 400 stocks, making this ETF very top-heavy. Therefore, investors may be forced to rely on just a few stocks to carry to overall performance while a greater number of holdings have virtually no impact.

Strong Banking Focus

The financial sector has seen a shift in preference towards larger banks over regional banks since the regional banking debacles in March. In addition to this momentary case, larger banks like the ones held in FNCL could be generally advantageous in the long run. Some fundamental edges include stronger balance sheets, greater access to capital, and generally greater robustness.

The most represented bank in this ETF is JPMorgan Chase (JPM). I don't usually address individual stocks when covering ETFs, but JPM could be a stock worth noting. On this same note, JPM is likely to be one of the primary drivers of this ETF in the future, as it accounts for almost a tenth of total holdings.

JP Morgan Chase has recently displayed the capability to excel during moments of panic and uncertainty, which is mostly attributable to this institution's market-leading stance and robust balance sheet. I believe JPM's position as a top holding could provide FNCL with positive momentum during moments of market downturn, granting some recession shielding to FNCL.

Financial Exposure Beyond Just Banks

Banks are a primary focus of this ETF as well as a primary focus of many investors at the moment, but FNCL's holdings are not limited to that of banks. This ETF also represents several companies centered on insurance as well as credit cards.

Berkshire Hathaway Inc. (BRK.A) ( BRK.B ) is the top holding in FNCL, and happens to not be a bank. Similar to JPM, BRK could serve this ETF with positive momentum in the long-term. BRK has so far outperformed the market during the last three recessions while also providing financial assistance and liquidity to adjacent businesses during times of market struggle. Though past performance is not necessarily indicative of future performance, BRK's performance during unforgiving times may reflect some fundamental recession-hedging capabilities.

Procyclicality And Fundamental Caveats In This ETF

FNCL may be a more stable investment compared to ETFs focused on just banks, but this ETF is by no means recession proof. FNCL and similar ETFs could actually be some of the first to suffer during the onset of a recession , making this ETF quite procyclical. Furthermore, financial stocks like the ones held in FNCL are prone to regulatory scrutiny which could potentially hinder profits in the future. This could also manifest sooner rather than later, as March's bank failures have called for tighter lending practices and other regulatory measures directed at financial institutions.

This ETF's volatility is quite high as it's uniquely vulnerable to the effects of market sentiment.

Preference for FNCL and similar funds is likely to oscillate with market cycles, creating large price fluctuations that might not be to the taste and risk tolerance of some investors. In the same regard, this ETF's top-heavy anatomy puts an ample amount of performance up to just a few stocks. Though these stocks have shown to perform well even amidst harsh conditions, the concentration risk stemming from this could deter some investors in the long term.

Past Performance And Future Implications

FNCL Vs. Alternatives: A Broad Focus Pays Well

FNCL's price trend during the past year is relatively stable compared to alternatives whose focus is more exclusive to one financial subsector like banking or insurance. Though this ETF doesn't reach the same heights as these peers, it also doesn't incur as big a drop when investor sentiment shifts towards fear. It's also apparent that FNCL has generally smaller price fluctuations and is less volatile than its potential alternatives.

A similar trend appears when looking back three years, as seen in the chart below.

Price Trend Analysis: Positive Momentum Emerging Slowly

FNCL is yet to break back above the 50-day moving average since its March decline, but it does appear to be creeping up slowly. Bank earnings reports could also provide this ETF with some positive momentum, as earnings have reflected a resurrected confidence in the financial sector. However, this prospect is still somewhat short-term and subject to change. While this ETF could emerge back above the 50-day moving average quite soon, one might also want to consider the room it has to fall while the market can't make up its mind.

What's Next For This ETF?

Bull Case

Regional banks have been on the decline since the crises in March, which has sent more depositors over towards larger banks like the ones in FNCL. As seen in the chart below, the smaller banks appear to have done significantly worse than the broader market and financial sector alike.

On the other hand, FNCL appears to be gaining some positive momentum along with the S&P. This could be associated with the recent increase in deposits , which was somewhat of a surprise given what the financial sector has gone through recently and could still incur in the near future. Evidently, fewer regional banks and increasing deposits means more deposits flowing towards larger banks, which could push the price of FNCL in the right direction.

Bear Case

Just as bank earnings indicate things may be looking up for financials, other metrics show that the market still has ample room to fall, and a crash could occur sooner rather than later. In particular, the treasury general account (TGA) has dropped below $87M, which in the meantime has provided the market with excess liquidity. However, this could be due for a reversal when tax receipts roll in.

In the event of a reversal, this excess liquidity would dry up and subsequently cause the stock market to decline. Financials could be the first to suffer from this development.

The economy is also likely due for more rate hikes and possibly a recession before the market is significantly restored. Though the recession may not be a big one, a recession of any size could significantly threaten this ETF, as investors have displayed no hesitancy to overreact in the past. Furthermore, an economic downturn could hurt FNCL via reduced M&A activity within banks as well as increased claims costs for insurance companies.

Conclusion

FNCL could be a solid choice and smaller alternative to XLF in the long-term, but now might not be the prime time to make salient decisions regarding financial assets. On this note, FNCL is a Hold for the time being. However, this ETF is also approaching buying range and I could see myself upgrading it in the future. Time will tell with this one, but I am choosing to play it safe in light of future rate hikes and monetary policy tightening.

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