The Financial Frontier: Some Financial ETFs May Be Worth the Risks

Over the last year, few areas of the stock market experienced more heartache than financial services. Words like liquidity and sub-prime infiltrated our vocabulary; meanwhile, portions of our portfolios recognized painful losses.

Some of the panic selling was justified. Scores of financial companies were holding onto billions in worthless sub-prime debt. In contrast, some of the beating was guilt by association, as Goldman Sachs investors found out.

Nevertheless, it is likely that the effect of the credit crunch effectively ended with the collapse of Bear Stearns. Since that time, credit spreads have improved, write-downs have been revealed and top-level analysts are beginning to discuss the opportunities of getting in on the financial services upswing.

Exchange-traded funds may be the best way to get exposure to some of the beaten-down "financials;" in particular, you'll get the diversification that helps you avoid holding onto a bank that "goes under." And, you’ll get the potentially lucrative bargain that comes from purchasing a collection of quality companies at significant discounts.

1. INSURANCE. The world's richest man, Warren Buffett, amassed his fortune in the 2nd oldest profession: insurance. And he's recently been touting his fledgling foray into his bond insurance business. Moreover, you have the aging baby boom population turning in an increasing numbers to products from long-term care insurers.

Enter the iShares Dow Jones Insurance Index Fund (IAK). Morningstar recently suggested that the fund's price was trading at an 18% discount to fair value. And while this fund's collective price-to-earnings ratio of 12 may not be considered a "steal," the 1.4 price-to-book makes the purchase reasonable for the long haul. (Read more about IAK here.)

One caveat: The 17% weighting to the world’s preeminent property/casualty player, American International Group (AIG), is a tie that binds. If AIG struggles to get its act together, results for the iShares Dow Jones Insurance Index Fund (IAK) would correlate.

2. INVESTMENT SERVICES. The iShares Dow Jones Broker Dealers Index Fund (IAI) makes it possible to invest in companies that broker financial transactions and/or offer investment guidance. Morgan Stanley, Lehman, Goldman Sachs, Merrill Lynch, Schwab -- 29 companies from the Dow Jones Investment Services Index. (Read more about IAI here.)

The problem here is obvious. Few companies were more tied to sub-prime greed turned sub-prime meltdown than the big investment banks. Still, the 35% high-to-the-low already accounts for much of the downside in price depreciation. And when liquidity makes a full comeback, the portfolios of mortgages could possibly serve as a source of surprising profitability.

3. BANKING. Alright… so you've had it with the mortgage mess. It's getting harder to tap home equity. And you keep hearing credit card delinquency will be the next shoe to hit the pavement.

Nevertheless, a long-term thinker might want to consider the streetTracks KBW Bank Fund (KBE). The 5% dividend yield alone makes this diversified ETF a worthy contender against treasury debt.

If you do not believe that the big banks are toast with butter or jam, KBE may be worth a look. Wells Fargo has an enormously loyal clientele. Bank of America has the lion's share of the U.S retail banking market, and will soon have the lion's share of the mortgage business with its acquisition of Countrywide. Meanwhile, the Federal Reserve literally handed Bear Stearns to JP Morgan Chase on a platinum platter.

All of the banks will benefit from the low interest rate environment such that margins of profitability can only increase. And none of the big banks are likely to fail with the Federal Reserve watching their backs.

The biggest risk with the streetTracks KBW Bank Fund (KBE) may be the 40% allocation to the top 5 holdings. If you worry about Wachovia and Citigroup, you may feel skittish about owning the this one.

Keep in mind, the ETFs I've highlighted above are not recommendations to get in; rather, they are ways to participate on the financial frontier... should you choose to seek new fortunes on challenging terrain.

Disclosure Statement: ETF Expert is a web log ("blog") that makes the world of ETFs easier to understand. Pacific Park Financial, Inc., a Registered Investment Advisor with the SEC, may hold positions in the ETFs, mutual funds and/or index funds mentioned above. Investors who are interested in money management services may visit the Pacific Park Financial, Inc. web site.