Betting Big on the U.S. Economy

 | Apr 17, 2012 | 10:00 AM EDT
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The U.S. financial sector 2012 has a lot in common with the 1840s California gold rush: There's so much opportunity, but so many terrifying risks as well. Financial stocks have been showing significant volatility for the last several years, posting big gains during market rallies but struggling mightily when uncertainty and anxiety spike. While volatility gives many investors heartburn, it undeniably creates big opportunities for those skillful enough to anticipate swings in market sentiment. Today I'm diving into a financial ETF that doesn't have nearly the assets or trading volume of a fund like Financial Select Sector SPDR (XLF), but can be a pretty useful tool for beefing up exposure to a narrow segment of the U.S. financial industry. 

There are a couple of investment theses bundled into iShares Dow Jones U.S. Broker-Dealers Index Fund (IAI), each of which may have its own unique appeal. First is the exposure to stock exchanges, a corner of the financial market that has seen expanding margins in recent years amid significantly higher trading activity and the increasingly complex, rising number of products available to investors. With substantial allocations to stocks such as the CME Group (CME), at 6.5% of holdings; IntercontinentalExchange (ICE) at 5%; and NYSE Euronext (NYX) at 5%, IAI offers a way to overweight this segment of the financial sector.

But stock exchanges aren't the only types of companies found in IAI. The ETF also holds a number of well-known asset-management firms. Among the biggest holdings in this fund are companies like Ameriprise (AMP), Charles Schwab (SCHW), Morgan Stanley (MS) and Raymond James (RJF). Those firms manage billions of dollars each, accounting for a significant portion of the domestic money-management business.

That makes IAI a very risky trade -- but it's one that can pay off big time when markets are rising. Think of this ETF as a leveraged play on the U.S. economy. It could struggle mightily when stocks fall, but should deliver some big gains in bull markets. That's a result of the revenue model for many of the component securities, which generally earn a percentage of the money held in the portfolios they manage. So when prices are climbing and investors are happy, so too are asset managers -- their 1% fee is being applied against a much larger base of assets.

There is, of course, a flip side to that coin: When stock prices are tumbling, so too do the values of client portfolios. That translates into smaller management fees and thinner margins. IAI truly is an ETF to invest in the business of investing.

IAI has a beta of nearly 1.6, indicating that it exhibits significantly higher volatility than that of the broader equity market. For all the reasons I outlined above, that shouldn't be a surprise at all. It also sheds some light on how investors might want to use a fund such as IAI. I'm not sure this ETF deserves a place in many long-term, buy-and-hold portfolios. The component stocks are generally included in broad-based equity funds, and the volatility might be to the detriment of standard investment objectives. But, for those looking to dial up risk in anticipation of a run higher (or in response to an overdone selloff), IAI might be a very useful tool indeed.


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