Two global financial ETFs to consider for your portfolio

The United States Federal Reserve has just hiked interest rates – a monumental development for equity markets.

Higher interest rates are no surprise. Rising fuel, energy and food costs in the US have put a rocket under inflation. Annual inflation in the US was 7.9% in February.

It’s hard to see inflation cooling anytime soon as Russia’s invasion of Ukraine pressures oil, wheat and other commodity prices. Then there’s growing wages pressure as higher living costs encourage workers to push for bigger pay rises.

The big surprise is that some central banks have taken so long to lift rates. The Bank of England has raised rates twice this year, but the US is just starting. In market parlance, central banks, including ours, are “behind the curve” with their response to higher inflation.

The result: central banks will have to move sooner and more aggressively than they expected. That’s never good for equity markets. Some investment banks predict the US Fed will raise rates seven times this year, or 1.75% in total.

It’s hard to overstate the significance of this period for equity markets. After 40 years of falling government bond yields – they even went negative in parts of Europe during COVID-19 – the tide is turning. Equity investors now face a period of rising inflation and interest rates, something many have never experienced.

Who knows how long this cycle of rising rates will last. Some banks tip a series of rate rises from now until 2024. That will vary by market, but at least a few years of rising rates seems likely. Geopolitical tensions add to inflation uncertainty.

Long experience has taught me that cycles often last longer than people expect. This rate cycle could be shorter because households are so indebted; even small increases in rates will make a difference to consumer demand and inflation.

So, how should investors respond to a period of rising inflation and rates? First, recognise that equity-market returns will be constrained. The big returns in the second half of 2020 and 2021 were an aberration.

Higher interest rates reduce the value of future cash flows and thus the net present value of assets. Simply, assets are worth less when the cost of capital rises. There are always exceptions, but rising rates are generally a headwind for sharemarkets.

The other risk is loss of purchasing power. If I’m right and equity markets deliver single-digit returns for a while, investors will think harder about their purchasing power as inflation takes off. For example, a 7% total return from equity markets in a year looks a lot less attractive if inflation is 4-5%. The real return is not enough to live on.

On stock selection, I’m wary about talk that investors need to own companies with higher pricing power that can pass on cost inflation. Such advantages are well known and priced into valuations long before commentators talk about them.

Also, I’ve seen some average companies with low pricing power do well during higher inflation. They got away with price rises when competitors lifted their prices and consumers expected price rises for goods.

Investors should favour sectors that can outperform when rates rise. Banks are an example. Typically, they benefit from expanding Net Interest Margins (the amount a bank earns on its loans compared to the amount it pays on deposits) when rates rise. Higher rates also point to a stronger economy and rising credit demand.

Banks won’t have it all their way. If inflation is higher than expected, and central banks are forced to lift rates more aggressively than markets predict, global recession could follow. Recessions create bad debts and crimp credit growth – that’s bad for banks.

I favour US and European banks over Australian ones, on valuation grounds. Offshore banks are harder for Australian retail investors to buy directly, so gaining exposure through Exchange Traded Funds (ETFs) on the ASX is an option.

Here are two global financial ETFs to consider:

1. BetaShares Global Banks ETF – Currency Hedged (BNKS)

In December 2020 for this report, I nominated BNKS as one of my top-five ETFs for 2021. BNKS had a total return of almost 29% in 2021.

BNKS’ top holdings are Bank of America, Wells Fargo, JPMorgan Chase, Royal Bank of Canada and Toronto Dominion Bank.

By geography, about 56% of the ETF is invested in the US and Canada, 16% in Asia and 8% in Britain. It’s a shame that so little of the ETF is allocated to European banks, which look undervalued at current prices.

Bought and sold on the ASX like a share, BNKS is an easy way to get exposure to a portfolio of global banking stocks. As an index fund, you only get the market return with BNKS. For investors seeking diversified banking exposure, that might be enough.

On valuation, BNKS traded on a forward Price Earnings (PE) ratio of 9.4 times at end-February 2022, BetaShares data shows. For comparison, Commonwealth Bank of Australia trades on a forward PE of 20 times, on Morningstar numbers. That reinforces the value in overseas banks compared to those in this market.

The other benefit of BNKS is sector diversification. Many Australian retail investors are overweight local bank stocks in their portfolio. Adding global bank exposure diversifies bank holdings, although investors should consider their overall exposure to the financial sectors within their portfolio and whether it is appropriate.

After rallying in 2021, BNKS fell 3.5% in February 2022, amid broader market weakness. Over five years, its average annualised return is a paltry 3.2%.

Global banks have a lot of catch-up ahead after underperforming for years due to falling inflation and falling government bond yields. BNKS’ annual management fee is 0.57%. 

2. iShares Global Financials ETF (IXG)

IXG is another option for investors seeking exposure to global banks. It goes a step further than BNKS by including investment funds and insurance stocks. IXG’s biggest holding is Berkshire Hathaway Inc Class B shares.

By sector, banks comprise 46% of IXG, followed by diversified financials at 32% and insurance companies at 21%. In 2021, I wrote favourably on insurance stocks for this Report, believing some insurers are undervalued and will benefit as rates rise.

IXG has returned 25% over one year to end-February 2022. Over five years, the average annualised return is 9.3%.

On valuation, IXG’s trailing PE ratio was 10.3 times at end-February, iShares data shows. IXG’s price-to-book ratio was 1.26 times.

Again, this illustrates the relative appeal of global financial stocks at current valuations. As beneficiaries of rising rates (on average), an overweight exposure to financials in the global equities component of a portfolio is warranted.

As to the two ETFs mentioned, I prefer BNKS mostly because I seek exposure to bank stocks. But the extra diversification in IXG could appeal to investors who want broader exposure to global financials across banks, insurers and wealth managers.

Another reason I favour BNKS is its currency hedging. With heightened geopolitical risk, I want to remove currency risk from the investment equation with global bank stocks. Higher commodity prices suggest a slightly higher Australian dollar this year.

IXG’s annual management fee is 0.43%.

Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. All prices and analysis at 17 March 2022. This information was produced by Switzer Financial Group Pty Ltd (ABN 24 112 294 649), which is an Australian Financial Services Licensee (Licence No. 286 531This material is intended to provide general advice only. It has been prepared without having regard to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice. This article does not reflect the views of WealthHub Securities Limited.