XLF - SEF: If You're Bearish On Financial Stocks You Might Like This ETF

2023-04-10 17:13:58 ET

Summary

• SEF is an ETF that aims to deliver the opposite performance of the Financial Select Sector SPDR ETF.
• The financial sector is making the wrong kind of headlines for the first time in 15 years, and this ETF tries to profit from that, without leverage.
• I'm neutral on financials and SEF short term (thus a Hold rating), but I see potential for this ETF to be a huge winner, probably suddenly, during the next 12-18 months.

By Rob Isbitts

With all of the opinions and financial media out there, my favorite "niche" research coverage area is what I refer to as "undiscovered" ETFs. ProShares Trust - ProShares Short Financials ( SEF ), which has been around since June of 2008, and currently holds a measly $40mm in AUM, clearly fits that description. But with the banking sector suddenly in hot water, and the potential for those issues to spread to the broader financial sector (as it often does), this non-levered method of profiting from declines in financial stocks should be a big winner.

After 15 years of "easy money" thanks to central banks keeping rates too low for too long, and essentially endorsing irresponsible financial behavior by banks, other corporations, consumers and investors, things are doing what they do in latter parts of a bear market cycle: They are breaking. First, it was a small number of isolated banks. Now, everything from regional and community banks, to diversified financial companies and the recipients of loans from those banks and from public market investors, is in play to "break."

And, while it's always possible that we've seen the worst of it, my assessment is that risk of a "credit event" is as high as it has been at any point since 2008, ironically around the time SEF debuted. So, it follows that investors should be identifying ways to profit if the dam breaks again. The impulse from many corners of the investment world is to use levered ETFs. I'm not a big fan of that approach, either long or short. I'd rather use a single-inverse ETF like SEF, which can go from being a -1x beta to the financial sector in normal times, to a much higher beta to the broader stock market at times when the financial sector leads the market down. The risk of that is growing. Thus, SEF is on my watchlist for ways to pounce on the opportunity to profit from the next stage of the bear market in stocks.

Because if the bear does continue, this phase is setting up to be the fastest, sharpest phase to the downside. Why? Because as I've mentioned ad nauseum in several recent articles, the bearish evidence is like a skyscraper, while the bullish counter argument has been reduced to "the Fed will pivot" and "there's too much money on the sidelines." Been there, heard that, profited from it when it doesn't happen and the bear attacks. Every cycle since my 1986 debut in this industry has played out that way. Maybe this time is different, which is why I also track several long equity ETFs. But risk is high, regardless of what actually happens.

SEF: Simply constructed, but there are clear risks

SEF primarily uses swap contracts with major world financial institutions to create a portfolio that, on a daily basis, targets a return opposite the S&P 500 Financial sector (which is captured on the long side by XLF). The main issue with swaps, potentially, is counterparty risk. Those of us old enough to remember investing through 2008 and even back to 1987 know that there can come a time when no one in the financial industry trusts anyone else. We saw a micro version of that in the recent bank runs. Nothing says "I don't trust you" as much as pulling money out of a bank when FDIC insurance covers your deposits!

As this holdings snapshot shows, SEF's portfolio of swaps is allocated across seven major financial institutions, the ones that are believed by many to be "too big to fail." That makes this about as high quality a swap portfolio as one could expect. But to be clear, this approach is different from shorting the stocks in XLF.

XLF is not a bank ETF. As shown below, banks are about 1/4 of the holdings, so SEF is essentially 25% short the banks, as an example. Furthermore, an investor also can buy put options on XLF to try to profit from a decline in this sector. That involves a time factor, since options have expiration dates, and SEF doesn't.

Why isn't SEF more popular with investors?

Don't ask me, that's why I wrote this article! Seriously though, I continue to be amazed at how much money flows into leveraged inverse ETFs at the expense of single (-1x) ETFs. Whether it's the major stock indexes, Treasury or high-yield bonds, or a sector like financials, I look at portfolio management as a combination of offense and defense, at the same time. And, with the equity market offering a lot of volatility but stagnating returns for over 15 months now, I see tremendous opportunity in lining up a portfolio very simply:

1. Own what I like "long" via ETFs (and/or call options)

2. Own what I don't like "short" via single-inverse ETFs (and/or put options)

The goal is to profit from the outperformance of one over the other, but also recognizing that you could win both ways. Here's a recent example.

Albeit this was a short time frame, only two months. But when you see moves like that in two months, I think the time is less of a factor. I can count on many hands the time I bought something as a "long-term ETF position" and saw it hit my price target within a month or too. One of the biggest myths in investing today is that "tactical" management isn't useful. This is the phase of the market cycle where gains in the equity market, if at all, are fleeting. Not adjusting, at least for now, to that reality is an alpha detractor.

In the chart above, let's say you were long technology stocks and short financials. As they say, it's a market of stocks not a "stock market," so being short one sector and long another can be a nice way to roll, at least with the tactical portion of your portfolio.

Now, you can use levered ETFs to try this type of fund pairing, but then you introduce all types of additional volatility. I'm more of a "meat and potatoes" investor, albeit with a very wide variety of ETF tools at my disposal. I encourage investors to recognize that there is more to the ETF market then the 10-20 funds that dominate asset flows. Instead, look to arm yourself for nearly any market scenario, including 1x inverse ETFs like SEF.

From the chart above, it appears that I'm not talking and writing to myself here. That spike in 30-day rolling share volume traded in SEF is not a coincidence. Interest in shorting the financial sector is growing, and for good reason. If there's not "another shoe to drop" following the recent near-calamity in the sector, it might be the first time in my career, going back to 1986. Regulators stuffed a lot of new regulations into the marketplace over the past 15 years, but there's no guarantee they will work in practice. They're now starting to be tested.

But at the end of the day, investors vote with their feet, so to speak. To me, that makes me a close follower of SEF and just about any other single inverse ETF. I rate it a Hold right now, only because technically (see chart above) there seems to be a pause in the ascent of the 20-day Exponential Moving Average - EMA - following the strong recent move up in SEF's price. That's the simplest, but one of the most reliable, bottom-line indicators I follow, among many. So, I'm a hold on SEF for now, but I'm poised to be right there if and when the current financial stock malaise resumes its downside run.

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