XLF - The Vanguard Financials ETF: Timely Or Time Up?

Summary

• As most of you know, rising interest rates are typically a positive catalyst for banks because their net-interest-margin ("NIM) rises and that leads to increased profits.
• Obviously, we have been - and arguably still are - in a rapidly rising interest rate environment. As a result, NIM is rapidly rising as well.
• That being the case, today I'll look at the Vanguard Financials ETF to see if it might deserve an allocation of capital within your well diversified portfolio.
• The short scoop: VFH's expense fee is 0.10%, the 10-day SEC yield is 2.34%, the 10-year average total return is 11.55%, and the #1 holding is Berkshire Hathaway (8.6%).

I suppose the Vanguard Financials ETF ( VFH ) is a timely ETF to write about on Seeking Alpha given that today (Friday the 13th) is the Q4 release date for earnings from the biggest U.S. banks, including JPMorgan Chase (JPM), Bank of America (BAC), Citigroup (C) and Wells Fargo (WFC) - all of which are held in the ETF. However, going forward - and considering that the Federal Reserve is likely closer to the end of the current rising interest rate cycle than the beginning - does the Financial Sector still deserve your investment dollars? Today, I'll take a closer look at the VFH ETF to try and gain a perspective of the financial stocks given where we are in the current interest rate cycle.

Investment Thesis

As most of you know, the Federal Reserve has raised the key Fed Funds rate from near 0% at the start of 2022 to the current 4.1% - an unprecedented and rapid increase. That said, the last increase was only 50 basis points (down from 0.75%) and expectations are that the next increase will be only 25 basis points. While that likely indicates the Fed is closer to the end of its rising interest rate strategy as compared to the beginning, Fed members are still ruminating about the need to take rates up to 5% and hold them there until inflation is adequately under control.

As mentioned previously, rising rates are typically good for banks because NIM generally increases (i.e. the difference between interest paid and interest received, adjusted for the total amount of interest-generating assets held by the bank) because banks can lend money at significantly higher rates than that at which it borrows money. Indeed, NIM has risen dramatically over the past three quarters:

But, of course, investing in financials isn't solely about NIM. That's because they also generate revenue from operations in equity trading, making deals, IPOs, commodities trading, and personal banking.

Today is a good day to review the Financial Sector considering that Q4 results for the four biggest banks in America were released this morning. So, let's take a look to see how the VFH is positioned to benefit investors going forward.

Top-10 Holdings

The top-10 holdings in the Vanguard Financials ETF are shown below and were taken directly from the VFH ETF webpage , where investors can find more detailed information on the fund. The top-10 holdings equate to what I consider to be a moderately diversified 41% of the entire 378 company portfolio:

The #1 holding with a 8.6% weight is conglomerate Berkshire Hathaway Class B ( BRK.B ) and its holdings in insurance, rail, and utility businesses. In addition, Berkshire holds a portfolio of publicly traded companies:

As can be seen, Apple ( AAPL ) is by far Berkshire's largest holding worth a whopping $123.7 billion. Considering BRK's investments in energy companies like Chevron ( CVX ) and Occidental Petroleum ( OXY ), it is notable that investing in the VFH ETF gives investors direct exposure to the Energy Sector as well.

Berkshire proved to be a shelter-in-the-storm during the 2022 bear-market by outperforming the S&P 500 by almost 14% over the past year. That's likely because BRK's FY22 earnings are expected to come in at $14.85/share - up 22.5% as compared to the $12.12 the company earned in FY21.

JPMorgan Chase ( JPM ), the largest U.S. bank, is the #2 holding with an allocation almost as large as Berkshire: 8.5%. JPM announced Q4 earnings this morning and they were a big beat on both the top and bottom lines with revenue of $34.5 billion (+17.9% yoy) coming in $270 million above consensus. Net interest income ("NII") was $20.3 billion, up a whopping 48%.

In a slide from today's Q4 Presentation, it's notable that JPM - led by closely followed CEO Jamie Diamond - expects NII margin of ~$74 billion in FY23 driven - interestingly enough - by expectations of two more Fed hikes, followed by two Fed cuts - ending the year at 4.50%:

The #3 holding in the VFH ETF is Bank of America ( BAC ) with a 5.7% weight. BAC also released Q4 earnings this morning that also significantly beat consensus estimates with revenue of $24.53 billion (+11.2% yoy) coming in $360 million higher than expected. NII of $14.7 billion was up $3.3 billion yoy (+29% ). However, non-interest income of $9.9 billion declined $799 million (8%) due to falling investment banking and asset management fees.

Wells Fargo ( WFC ) is the #4 holding with a 3.8% weight. WFC also released Q4 earnings this morning and they weren't near as impressive as those from JPM and BAC: revenue came in at $19.66 billion (-5.8% yoy) - a $380 million miss . WFC is still suffering from past digressions - with ($3.3) billion, or ($0.70) per share, of operating losses primarily related to a litigation, regulatory, and customer remediation matters.

The #9 holding is BlackRock ( BLK ) with a 2.3% weight. Of course Blackrock is not a bank, it's an investment management company. BLK also released Q4 earnings this morning and non-GAAP EPS of $8.93/share was an $0.86 beat even as revenue of $4.34 billion was -15.1% yoy. During the quarter, BLK had $146 billion of quarterly long-term net inflows while AUM totaled $8.59 trillion, up from $7.96 trillion at the end of Q3.

From a total financials portfolio perspective, the VFH ETF is nicely diversified as it has allocated capital primarily in the following sub-sectors:

• 21.3% - diversified banks
• 14.3% - regional banks
• 9.7% - investment banking and brokerages
• 8.8% - asset management
• 8.8% - financial exchanges and data
• 8.8% - property and casualty insurance

From a valuation perspective, the VFH ETF is arguably cheap:

I say that because in comparison the S&P 500 currently has a P/E = 20.6x , a price-to-book of 4.0x. That said, the S&P 500 also has an ROE of 23.1% , significantly higher than the VFH. However, investors should consider that ROE is a backwards looking indicator.

Performance

As mentioned previously in the bullets, the VFH ETF has a solid 10-year average annual total return of 11.55%:

The following graphic compares the five-year total returns of the VFH ETF with some of its competitors, including the iShares US Financials ETF ( IYF ), the Fidelity MSCI Financials ETF ( FNCL ), the SPDR Financial Select Sector ETF ( XLF ), and the SPDR S&P Bank ETF ( KBE ):

As can be seen, both the IYF and XLF ETFs have outperformed the VFH ETF. Also note that I added the KBE banking centric ETF in the comparison just to show how much the entire "Financials Sector" has outperformed the Banking Sector.

Risks

As mentioned earlier, NIM is a very positive catalyst for the Financial Sector, and that certainly proved to be the case in the Q4 earnings released this morning (as shown above). However, as I also mentioned, the financial stocks are also impacted by other operations - such as commodities trading, deals and IPOs, and personal banking - that can be greatly affected by the overall economic environment.

JPM CEO Jamie Diamond is considered to have excellent visibility into the U.S. and global economy, and therefore his "go-forward" commentary is widely followed. The following quote is taken directly from the previously referenced Q4 EPS release:

The U.S. economy currently remains strong with consumers still spending excess cash and businesses healthy. However, we still do not know the ultimate effect of the headwinds coming from geopolitical tensions including the war in Ukraine, the vulnerable state of energy and food supplies, persistent inflation that is eroding purchasing power and has pushed interest rates higher, and the unprecedented quantitative tightening. We remain vigilant and are prepared for whatever happens, so we can serve our customers, clients and communities around the world across a broad range of economic environments.

As you can see, Diamond remains concerned about the impact of Russia's ongoing conflict on Ukraine that broke that global energy and food supply chains and has led to higher and persistent global inflation. After all, that is a primary reason the Fed had to increase interest rates so rapidly last year - and it's not done yet.

In addition, of course, the high-inflation higher interest rate environment could cause the U.S. and global economy to contract and possibly lead to a severe recession. While I personally don't believe this will be the case - at least not in the US. Strong job-growth should continue due to large-scale government investment via the Biden administration's ability to (finally ...) pass a bi-partisan Infrastructure Act, as well as the CHIPS & Science Act and the IRA Act (which I refer to as the "Clean Tech Act").

Summary and Conclusion

Despite the rise in NIM over the past year, the VFH ETF is down some 15% and is currently down almost 1% this morning after some profit-taking on the banks after a strong run-up into their Q4 releases this morning.

However, I'm relatively neutral on this group - and rate it a HOLD - mostly because the S&P 500 has consistently outperformed the Financials sector as a whole:

That being the case, I don't see the need or rationale to make a Financial Sector specific investment. However, I should note that my perspective comes from the point-of-view of an investor who believes in the strategy of building a well-diversified portfolio built for the long-term and holding it throughout the market cycles. Since the VFH ETF doesn't appear to add any additional performance potential above and beyond that of the Vanguard S&P 500 ETF ( VOO ), the core position in my portfolio, I don't see the rationale to add it to my portfolio - or to yours.

For further details see: