Finance ETFs Ease Rate Pain - TheStreet

Banks and brokerage stocks have been huge winners over the last couple years, but with rates threatening to move higher, there are some definite advantages in switching out of individual financial names and into diverse financial sector exchange-traded funds.

Banks and brokerage stocks have risen since 2003, primarily because long-term interest rates have remained stubbornly stable. But Wall Street has grown anxious in the last month or so at the thought that the honeymoon is coming to an end. Rising rates hurt financial stocks, because they eat into the profit margins of institutions whose businesses revolve around the debt markets.

When a higher-than-expected core producer price index was announced in mid-February, for example, the fear of inflation caused the yield on the benchmark 10-year Treasury bond to jump 8 basis points to 4.26%. The rise in yields promptly led to heavy selling in financial shares. Soon after, a Bank of Korea announcement stating that it intends to diversify its currency holdings caused 10-year rates to rise 3 more basis points and sent financial stocks even lower.

Particularly at risk in this environment are brokerages with big bond-trading and debt-underwriting operations such as

Bear Stearns

(BSC)

and

Lehman Brothers

(LEH)

, which would feel the pinch if climbing rates were to dissuade new issuers from coming to market. Financial services firms tied to the mortgage market, such as

Fannie Mae

(FNM)

and

Freddie Mac

(FRE)

, would also be susceptible if higher borrowing costs brought down the soaring housing market.

"Higher rates may curb new-home sales and refinancings, which have been big moneymakers for the banks and financial services companies when rates were dropping," says Sam Stovall, market strategist at Standard & Poor's.

Investors have good reason to anticipate a step up in borrowing costs, considering that the

Fed

has lifted the overnight lending rate six times since last June. And most market analysts predict that it isn't done yet, thus making the situation even more slippery for the financial sector.

Investors looking to maintain exposure to the financial sector without absorbing the added risk of picking individual winners can opt for financial sector ETFs such as the

Financial Select Sector SPDR

(XLF) - Get Report

ETF, which trades like a stock but tracks all the financial companies found in the

S&P 500

. (Financials currently make up just over 20% of the S&P index.) Options are also available on this ETF for investors looking to sell covered calls or buy puts for added protection.

Other choices for investors who are confident that financial shares can prosper despite the Fed's heavy lifting can check out the

iShares Dow Jones U.S. Financial Services Index

(IYG) - Get Report

, as well as the

iShares Dow Jones U.S. Financial Sector Index

(IYF) - Get Report

. The difference between the two is that the IYG includes just bank and general financial services stocks, while the IYF also adds real estate and insurance companies such as

AIG

(AIG) - Get Report

to the mix. The cost for these two sector ETFs is 0.60%, or roughly a full percentage point lower than the average open-end sector mutual fund.

Low-priced leader Vanguard also offers a financial services ETF, the

Vanguard Financial Viper

(VFH) - Get Report

for an annual fee of 0.28%, which is the same cost as the XLF.

Nevertheless, interested investors should take note of the overwhelming similarities among the ETFs when it comes to their top holdings.

Citigroup

(C) - Get Report

, the world's largest financial services institution, comprises over 10% of the assets in each of the ETFs, while

Bank of America

(BAC) - Get Report

comes in a close second in terms of percentage weighting.

Rounding out the top 10 in the XLF, IYF and VFH in roughly equal portions:

AIG

J.P. Morgan Chase

(JPM) - Get Report

Wells Fargo

(WFC) - Get Report

Wachovia

(WB) - Get Report

Fannie Mae

American Express

(AXP) - Get Report

U.S. Bancorp

(USB) - Get Report

Morgan Stanley

(MWD)

The IYG, which doesn't include insurance companies, replaces AIG with brokerage giant

Merrill Lynch

(MER)

.

Investors unsure about holding Citigroup and Bank of America in such large doses might consider as an alterantive the

iShares S&P Global Financials Sector Index

(IXG) - Get Report

ETF. The weightings of those two banks are reduced substantially in this ETF because it adds foreign banks like

UBS

(UBS) - Get Report

to the mix.