The big question on everyone's mind this week was how could financial stocks and the funds that hold them have rallied in the face of such bad news?

NetBank failed on Sept. 28, with losses to some business account holders of as much as half a million dollars. It was the second bank failure for 2007, a rare event. No banks failed in 2005 or 2006. When federal regulators on Thursday announced the closing of a third bank, Miami Valley Bank of Lakeview, Ohio, it was downright shocking.

Reports this week by the industry leaders of $5.9 billion in credit and trading losses on loans and mortgage backed securities at Citigroup ( C - Get Report), a $5 billion writedown at Merrill Lynch ( MER) and a 75% decline in quarterly profit at Washington Mutual ( WM - Get Report) fly in the face of the subsequent rally.

So, what excuse can be given for the financial sector's rise?
  • The cheap U.S. dollar enticed Canada's Toronto Dominion (TD - Get Report) bank to by Commerce Bank (CBH - Get Report), possibly signaling a financial stock acquisition boom.
  • Big write-offs mark the end of the liquidity crisis.
  • The yield curve has normalized to a positive slope, allowing banks to pay less for short term deposits while using the funds for long term loans.
  • The Federal Reserve won't stop at one cut, so the party is just getting started.
  • Who cares? Don't knock it. It's working wonders in our portfolios!

Whichever justification you choose, the Ultra Financials ProShares ( UYG) made the most of it, returning 6.50% for the five trading days ending Oct. 4. This exchange-traded fund is leveraged 200% to the Dow Jones U.S. Financial Sector Index. In second position this week is the First Trust/Gallatin Specialty Finance and Financial Opportunities Fund ( FGB), a closed-end fund, pulling in 6.00%.

Also indexed to the Dow Jones U.S. Financial Sector Index, the ( FNPIX - Get Report) ProFunds Financials UltraSector ProFund used 150% leverage to gain 5.10% this week. The largest holdings are Citigroup, Bank of America ( BAC - Get Report) and JPMorgan Chase ( JPM - Get Report). The biggest gainers held by the fund are Lazard ( LAZ - Get Report) up 10.86%, Kilroy Realty ( KRC - Get Report) up 9.93%, Mastercard ( MA) up 9.16%, and Federal National Mortgage Association ( FNM) up 8.69%.

Best Performing Financial Funds
Ranked by returns for the week ending October 4
Fund Ticker Rating Fund Type 1 Week Total Return
Ultra Financials ProShares UYG U ETF 6.50%
First Trust/Gallatin Specialty Fin and Finl Opportunities Fund FGB U Closed-End 6.00%
ProFunds Financials UltraSector ProFund FNPIX E- Open-End 5.10%
Alpine Dynamic Financial Services Fund ADFSX U Open-End 5.01%
KBW Capital Markets ETF KCE D ETF 4.97%
WisdomTree International Financial Sector Fund DRF U ETF 4.96%
iShares Dow Jones US Broker Dealers Index Fund IAI D ETF 4.61%
Fidelity Select Brokerage & Investment Management Portfolio FSLBX C Open-End 4.50%
AXA Enterprise Global Financial Services Fund EGFBX D+ Open-End 4.24%
Morgan Stanley Financial Services Trust FSVAX E- Open-End 4.13%
Source: Bloomberg, Read this for an explanation of our ratings.

The only fund focused on the financial sector to fall this week is the one designed to buck the trend of the sector. The UltraShort Financials ProShares ( SKF) fell 5.96% over the five trading days, by targeting -200% of the daily performance of the Dow Jones U.S. Financials Index.

Of the funds taking the long side of the financial sector, the ( BURKX) Burnham Financial Services Fund was the dog of the week. This open-end mutual fund, with our lowest possible rating of E-, gained just 0.53%. Buyers of this fund who paid the 5% front load would have lost money.

Worst-Performing Financial Funds
Ranked by returns for the week ending October 4
Fund Ticker Rating Fund Type 1 Week Total Return
UltraShort Financials ProShares SKF U ETF -5.96%
Burnham Financial Services Fund BURKX E- Open-End 0.53%
PowerShares Financial Preferred Portfolio PGF U ETF 1.09%
Forward Emerald Banking and Finance Fund HSSAX E Open-End 1.43%
KBW Regional Banking ETF KRE D ETF 1.60%
Burnham Financial Industries Fund BURFX C Open-End 1.70%
John Hancock Financial Trends Fund Inc JHFT C Closed-End 1.70%
Senbanc Fund SENBX E- Open-End 1.98%
Diamond Hill Financial Long-Short Fund BANCX E Open-End 2.08%
PowerShares Dynamic Banking Portfolio PJB U ETF 2.18%
Source: Bloomberg, Read this for an explanation of our ratings.

Friday morning, along with the announcement of 110,000 new non-farm jobs for September, the Bureau of Labor Statistics revised August to a gain of 89,000 jobs from a loss of four thousand. This reduces the chance of a second Fed interest rate cut coming on Oct. 31.

On the other hand, the bulls are hoping for another cut. They're hanging their hat on the U.S. unemployment rate, which ticked up to 4.7%, the highest level in 13 months, and the larger than expected loss of manufacturing jobs.

Next week's retail sales and inflation figures should give us a better understanding of U.S. economic health and whether or not inflation is low enough to risk another rate cut.

Kevin Baker became the senior financial analyst for TSC Ratings upon the August 2006 acquisition of Weiss Ratings by, covering mutual funds. He joined the Weiss Group in 1997 as a banking and brokerage analyst. In 1999, he created the Weiss Group's first ratings to gauge the level of risk in U.S. equities. Baker received a B.S. degree in management from Rensselaer Polytechnic Institute and an M.B.A. with a finance specialization from Nova Southeastern University.