Spotlight on Global Financials

The financial sector comprises approximately 20% of both the S&P 500 (SPY) and Global 100 (IOO) indexes and is essentially a co-owner of the world's personal and corporate assets. Unlike companies in most other sectors that purchase assets, employ them productively, and expense the depreciation against earnings, post-Enron accounting standards require financial companies to continuously revalue their assets based upon market prices and immediately report any significant losses. In Q3, falling prices of securitized assets forced more than $40B of writedowns that reduced US YoY financial sector (XLF) earnings by a third and cut the one year return of the two broad indices by 4.0 and 3.2 points respectively. While more Q4 write-downs are anticipated, next year's earnings will likely look better by comparison and at some point asset prices will move higher, albeit from a lower basis. Ultimately a healthy financial sector is both the cause of and the beneficiary of global growth, and in the long-term earnings are related to the performance of all of the other sectors of the economy.

Investors of international ETFs are often stunned by the extremely high percentage of holdings in the financial sector, especially in Europe and Asia. In those regions, equity investment is often not as prevalent as it is in the US and the UK (EWU), and consequently banks and other financial companies play a larger role in the economy through debt financing. Also many smaller countries such as Singapore (EWS), Hong Kong (EWH), and Belgium (EWK) have specialized in financial services and serve a large regional market. In 2004, Ernst & Young estimated that Asian banks had more than $1T of non-performing loans on their books and Europe had more than $300B. While global improvements have been made since then in both accounting disclosure (via the adoption of Basel II) and asset disposal, these numbers make the US sub-prime problem look small by comparison. Investors in overseas banks should never assume that a lack of immediate writedowns means that there are no losses. In 11 out of the 23 country index ETFs analyzed, more than one third of the stock market capitalization is concentrated in the financial sector and/or shares of one single financial sector company makes up more than 10% of the ETF's holdings. The US is the only country in which no individual finance firm has more than 2% of the total stock market capitalization, likely due to increased specialization of smaller firms. As a result most of the regional and country ETFs have a high one-year correlation with IXG (IXG), the global financial sector ETF, with Canada (EWC) and Australia (EWA) being the significant exceptions.