Bank on insurance sector

April 20, 2016 01:00 PM

The one error that both investors and generals often commit is a tendency toward always fighting the last war. Technology stocks underperformed during the early stages of the 2003 to 2008 bull market as cautious investors were so focused on not repeating the errors of the dot.com era, when they ignored the bubble growing in financial stocks. Fast forward a few years and you’ll find it happening again as the financial sector Select SPDR Fund (XLF) has lagged behind the S&P 500 Total Return Index, which was up 10.13% on a five-year annualized basis through Feb. 29, 2016, while XLF was up a mere 6.43%.   

No one is saying the market didn’t have its reasons for avoiding the sector; a tremendous amount of capital had been destroyed in 2008, not to mention the legal woes from the mortgage crisis, skyrocketing default rates and declining net interest margins due to the actions of the Federal Reserve. Banks are among the primary beneficiaries of a steeper yield curve and the Fed’s zero-interest-rate policy has eroded profitability since 2011. And while the financial health of large banks has improved with loan defaults down nearly 50% since 2009, investors are always more concerned about the future than the past.

Treasury yields and financial stocks are highly correlated when rates are at low levels, so investors loved the banks again as the Fed normalized interest rates in 2015 only to run screaming the other way after economists concluded Fed Chair Janet Yellen and the rest of the FOMC hiked rates too quickly in December. The rush back into Treasuries sent bank stocks plummeting, but were investors too quick to pull the trigger? By late February the situation had become so dire that according to Bloomberg, you could buy Bank of America (BAC) and Citigroup (C) at a price-to-book multiple of 0.56! The market was so terrified about a replay of 2008 that it priced the banks just below the going rate for China’s undercapitalized and overly stressed “Big Four” banks. If that’s not an example of “blood in the streets” I don’t know what is.  

But it takes a cast iron stomach to buy when others are panicking, which is why investors are looking at other ways to play the rising rate theme without taking on the higher volatility that can come with bank stocks. Instead of Real Estate Investment Trusts or other investments that are highly correlated to rates, perhaps it’s time to consider the least sexy investment of all time: Insurance stocks —which for once hold out the chance of a decent payoff while you’re still around to enjoy it. Like bank stocks, insurers are correlated to changes in Treasury yields, but typically have lower debt levels and more stringent oversight, making them substantially less volatile.       

Investors have a wealth of options in the insurance space but one fund making our screens light up is the highly-concentrated PowerShares KBW Property & Casualty Insurance Portfolio (KBWP). There’s a lot to like about this fund. Namely, it offers the right mix of upside participation when financials are rallying and reduced volatility, although we should point out that the fund’s focus is on more volatile mid-cap names.  During the 2015 rally from the start of February to the end of July, KBWP picked up more than 14.2% compared to an 18.3% gain for its sister bank share fund, PowerShares KBW Bank Portfolio (KBWB), while the fund’s standard deviation during the last three years was 25% less than KBWB (see “A better sector play”).  Warren Buffet famously said, “you should be greedy when others are fearful,” but that doesn’t mean you shouldn’t find a smarter way to do it.

About the Author

Matt Litchfield is content editor for ETF Global (ETFG.com) and is responsible for all posts and new product updates on ETFG.com. @ETF_Global