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Broker/Dealer ETF Takes a Beating

IAI is still reeling from the demise of Bear Stearns, but it may be a good buy for those who think the worst is over in the sector.

The iShares Dow Jones U.S. Broker-Dealers Fund (IAI) - Get iShares U.S. Broker-Dealers & Securities Exchanges ETF Report has seen its fair share of adversity this year.

Still struggling to bounce back from the

Bear Stearns


collapse, this ETF is down 22.6% year to date. Since hitting its 52-week low on March 17, the fund has gained 23%, but still remains 32.2% below its 52-week high achieved last June.

IAI's top holdings include names such as

Goldman Sachs

(GS) - Get Goldman Sachs Group, Inc. (GS) Report


Morgan Stanley

(MS) - Get Morgan Stanley (MS) Report


Merrill Lynch



Lehman Brothers

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Charles Schwab

(SCHW) - Get Charles Schwab Corporation Report


In the wake of massive writedowns, analyst downgrades and the prospects of tightened regulation, the investment banks may still have some pretty steep hurdles left before their stock prices really can begin to recover. However, in the event they are able to successfully clear these barriers, there could prove to be a sizable upside for shareholders.

"Looking ahead, I think these stocks will move forward in fits and starts with periodic jolts to the downside on credit fears," says Herb Morgan, CEO and chief investment officer of Efficient Markets Advisors. "The sector as a whole is relatively undervalued, though."

Ryan Lentell, a senior equity analyst for Morningstar, agrees with Morgan on the notion of choppy waters ahead.

"Long term, investors will do well investing in these banks," he says. "However, they should expect continued volatility in the near term. The issues in the housing and credit markets are not going to disappear overnight, and these concerns will continue to pressure the banks and produce negative headlines."

James Shelton, chief investment officer of Kanaly Trust, also believes that the short term could present a great deal of challenges for the sector.

"I think they are going to face a difficult second-half of 2008 based on reduced earnings power and the potential for additional losses," he says.

Investors who believe the worst is in the past would be best-served by using the ETF as opposed to trying to pick individual names, Morgan recommends.

"That's really the way to play it... If you are already in the red on any one of IAI's individual holdings, by selling the stock and going with the ETF, you could monetize your loss as well as decrease your risk."

Emiko Kurotsu, an analyst for Morningstar, also favors the use of the ETF, but says it might be too soon to dive back into the sector.

"Given the uncertainty that remains in this segment of the market, we'd recommend investing in a more diversified basket of financial stocks, in order to tamp down volatility," she says. "For a fund like IAI, we would need at least a 20% discount to our fair value estimate before it looks attractive. As of May 20, however, it was only trading at a 16% discount to our fair value estimate, which isn't a big enough margin of safety for our tastes."

Earlier this month,


Chairman Christopher Cox called for the SEC or some other financial regulator to be given clear authority to impose better oversight over the industry. Should regulation of this sort eventually come into play, it could prove to be a drag on profits.

"I wouldn't be surprised if you see the investment banks come together to better self-regulate and become more transparent out of fear of greater regulation," Morgan postulates.

Regardless of the form of any future regulation, it's likely that the investment banks will proceed to deleverage.

"Today, the form of any increased regulation is just conjecture," Lentell says. "It is likely that they will begin to operate with somewhat lower leverage, though."

At the time of publication, Billy Fisher was short LEH and GS.