Investoid

I am currently overweight financials in my retirement portfolio and will likely remain that way over the long term. I get my exposure to financials two ways currently:

1. Via the approximate 35% weighting financials have in the TSX/S&P Index, which I replicate using the TSX/S&P Index Capped iShares (XIC)
2. Via the TSX/S&P Financials iShares (XFN)

I like the Canadian financial stocks for several reasons:

1. Barriers to entry: the banks in Canada enjoy some level of barriers for their core services in Canada, from retail banking to investment banking and corporate services. While some small progress has been made by multinationals (such as ING) on the low end of financial services, their limited success only highlights how tough it is to break into this country.
2. Willingness to accept fees: as is currently being highlighted by the NDP, Canadians accept a lot of fees with little resistance. Whether it’s ATM fees, regular account fees or high mutual fund MERs, we seem to accept them all in stride, even when they increase (insert whatever cliché you wish about Canadians and our ‘nice’/passive personalities; it seems to apply here). This factor pads the profit margins of financial firms and is quite stable regardless of the economic cycle (less so for the mutual fund companies though).
3. Yield: in today’s low yield environment, it’s nice to get an extra 2-3% annually in a stable dividend. When government long term bonds are currently yielding only about 4%, you can really see the advantage to owning financials.
4. Currently, there is little to indicate that interest rates will be increasing in this country. Inflation (ex-housing) is pretty stable and low, while the economy is not growing that strongly. If anything, I see a rate decrease if the US housing collapse ends up affecting enough resource suppliers in Canada and depressing our GDP figures further.
5. Outperformance: since January 1, 2002 the financials have outperformed the capped iShares by 3% annually in terms of total return (all figures calculated based on figures available at Yahoo Finance Canada). Note that this does not provide any diversification away from the market risk associated with the TSX. The correlation between the XFN and XIC over this time period is 0.989, meaning you are not reducing your market risk in any meaningful way.

In the past 5 years financial stocks as a whole have risen steadily with only a few brief pauses or drops. In my opinion, you can’t go wrong buying XFN at nearly any time. But, if you’re already invested in XFN and are looking to get some additional return, here are a couple of tips.

1. Wait until there’s a slight pullback (4% or more) to purchase more. You may get a chance in the near future if Finance Minister Flaherty acts along the lines of his current comments and does something to restrict ATM fees or some other bank profit machine.
2. Pick the specific stocks which have consistently outperformed the financials index. Of the large banks, the two that pop up in terms of 5 year historical performance in Bank of Nova Scotia (BNS) and National Bank (NA). Both have outperformed XFN by at least 2.5% annually since January 1, 2002 on a total return basis. Of the two, BNS is less volatile, while NA has outperformed BNS by about 0.8% annually since 2002. Both offer solid yields in the 3.3% range.

I’ll update these to outright long-term buys if there’s a pullback on any of these three stocks in the near term without material news which affects their long outlook.