State Street has three interesting financial sector ETFs that are now listed and trading. The three new funds are the streetTRACKS KBW Bank (KBE), streetTRACKS KBW Capital Markets (KCE) and streetTRACKS KBW Insurance ETF (KIE).

ETF companies have created a lot of "me too" products lately, but these ETFs may have some promise, and I am especially interested in the Capital Markets ETF (KCE).

In general, investing in brokerage stocks, public exchanges and asset managers can be a way to add extra return in the financial sector. Simply put, bull markets and expanding economies may be most evident in this part of the market.

Take a look at Chicago Mercantile ( CME) or Archipelago Holdings ( AX) for some evidence.

Brokers In a Bull Market
Source: Roger Nusbaum

Until the KCE came along, the capital markets portion of the financial sector had been very under-represented in the wave of new investment products over the last couple of years. The largest stocks in this subsector, like Merrill Lynch ( MER) or Morgan Stanley ( MWD), don't have enough weight in the broad financial sector ETFs to allow investors to capture the effect.

KCE isolates this area nicely. The fund's breakdown is 41.53% full-service brokerage, 22.12% asset managers, 16.02% back-office processing, 12.09% discount brokerage, and 8.22% publicly traded exchanges.

Digging further into the nuts and bolts, you might expect some very large holdings in the fund, and there are. Goldman Sachs ( GS) makes up 10%, Merrill Lynch 9.5% and Morgan Stanley 8.5%. This shouldn't be too surprising, because narrow subsector ETFs are likely to always be heavily concentrated in a few holdings.

KCE will not have much, if any, yield. I plugged its holdings into Morningstar's software and saw that the portfolio might yield 1.09%, but the expense ratio of the fund is 35 basis points, leaving 74 basis points. That is my calculation, and State Street has not announced a dividend.

Dovetailing Nicely With Diversification Goals

The capital markets ETF could easily fit into a diversified portfolio as part of the financial sector allocation.

After the most recent run-up in the group, financials now comprise 21% of the S&P 500 index, so an investor wanting to maintain an equal weighting vs. the S&P 500 without much single-stock risk might have 18% in a broad-based financial ETF like Financial Select Sector SPDR ( XLF) and 3% in KCE. That might not seem like much exposure on its face, but with 13.6% of XLF invested in capital markets stocks, the overlap is actually 5.4% to this higher-octane part of the sector.

Also, the financial sector is a good place to add foreign exposure in both developed and emerging markets. For instance, an investor can put 16% in XLF, 3% in KCE and the remaining 2% in something like iShares Singapore ( EWS), which has a 35% weight in the bank sector and a 3.6% yield, or a common stock like Banco de Chile ( BCH), which has a 6% yield, and would give exposure to a relatively stable Latin American economy.

Either combination gives broad diversification within the sector, a chance to outperform the sector and not much in the way of single-stock risk.

Subsectors Carry Risks

As mentioned earlier, financials have a 21% weight in the S&P 500, and it has been around 20% for a while. Historically, growth beyond 20% has led to nasty declines. For example, technology in 2000 and energy in the early 1980s each grew to about 30% of the index, prior to disastrous drops.

Flat yield curves make lending money less profitable. The yield curve has been getting flatter and if inverted would make lending a losing proposition. This creates an obvious headwind for the banks.

Banks Beat Brokers on Flat Curve
Source: Roger Nusbaum

Although a flat or inverted yield curve would seem to be less of a fundamental problem for the stocks in KCE, the brokerage stocks in fact sold off more than the bank stocks the last time the curve flattened on its way to inversion at the start of this decade.

It is important to realize that given the potential for market-beating returns when times are good, KCE has a high probability of lagging behind the rest of the sector when times are bad.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, Ariz., and the author of Random Roger's Big Picture Blog. At the time of publication, Nusbaum had no positions in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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