The Financials sector ranks last out of the ten major sectors as detailed in our sector roadmap. It gets my Dangerous rating, which, like my fund ratings, is based on aggre­ga­tion of stock rat­ings for each of 563 companies in the sector. The Financials sector is the bottom of the sector barrel. The full series of my reports on the Best & Worst Sec­tor and Style Funds is here.

Despite ranking last overall, there is some opportunity in Financials Sector stocks. 87 stocks making up over 13% of the sector’s value are rated Attractive-or-better. This creates potential for Attractive-or-better-rated funds. However, per figure 1, managers are not allocating enough to Attractive-or-better-rated stocks. There is only one Attractive-rated fund, details in Figure 3. On the other hand, there are 220 Very Dangerous-rated funds, which represent over 88% of the assets allocated to funds in the sector.

Investors should avoid funds in this sector because the cost of portfolio management is not justified. Investors can outperform by picking a basket of the Attractive-or-better-rated stocks and avoiding the management fees.

Figure 1: Financials Sector Landscape For Funds & Stocks

Sources:   New Constructs, LLC and company filings

There are 270 funds to chose from within the Financials sector, and they are all very different. Per Figure 2, the number of holding varies widely (from 19 to 508), which creates drastically different investment implications and ratings. Here is the full list of 270 funds along with free reports on each one.

How do investors pick the right fund out of the sea of choices that will deliver the best returns?

Figure 2: Funds with Most & Least Holdings – Top 5

Sources:   New Constructs, LLC and company filings

To iden­tify the best funds within a given cat­e­gory, investors need a predictive rating based on analy­sis of the under­ly­ing qual­ity of stocks in each fund. See Fig­ure 2.

Our predictive fund ratings are based on aggregating our stock ratings on each of the fund’s holdings and all of the fund’s expenses. Investors deserve forward-looking fund research that is comparable in quality to stock research.

Investors should not rely on backward-looking research of past performance for investment decisions.

Figure 3 shows the five best and worst-rated funds for the sector. The best funds allocate more value to Attractive-or-better-rated stocks than the worst funds and vice versa. The five worst funds receive my Very Dangerous Ratings because of their poor allocations along their high total annual cost.  My ratings and free reports (updated daily) on all funds in this sector are here.

One of my favorite stocks in the Financials sector is Chubb  [s: CB], which gets my Very Attractive rating. First, Chubb gets a big thumbs-up for not being a bank. And, unlike most of the banks in this sector, Chubb is profitable. It generates real economic earnings, and its 15% ROIC is in the top quintile of the 3,000 companies we cover. Combining this strong profitability with a current valuation (~$67.68/share) that implies a permanent 20% decline in profits give this stock an excellent risk/reward profile.

Fittingly, the fund that invests the most in CB is the only Financial sector fund to get an Attractive Rating: PowerShares KBW Property & Casualty Insurance Portfolio [s: KBWP].

To celebrate the last of my Best & Worst Sector Funds articles and since there are so many Very Dangerous stocks in the sector, I am sharing two, not just one, of my least favorite Financial stocks: Citigroup [s: C] and JP Morgan [s: JPM}, both or which get my Very Dangerous rating. Though Citigroup’s stock has dropped 32% since being added to my Most Dangerous Stocks list on April 1, 2011, I think it has farther to go. As detailed in this article, Citi’s management is not above monkeying with the company’s accounting to overstate earnings. The same is true for JP Morgan, which recently exploited SFAS No. 159, a new accounting rule that enables banks to artificially boost earnings. Specifically, the company realized a $1.9 billion (pre-tax) “adjustment” for an extra  $0.29 per share in the 3rd Quarter from the decline in the value of its own debt. This loophole is just one in a long line of tricks that have enabled some of the major banks to mislead investors. More details are here. The valuations on both of these stock are sky high and leave investors with little upside potential and lots of downside risk, especially when (not if) any of the accounting tricks they employ come home to roost.

Fittingly, the fund whose two largest allocations are JPM (8.3%) and C (8.1%) gets my Very Dangerous rating as well. PowerShares KBW Bank Portfolio [s: KBWB] earns my worst rating by allocating nearly 43% of its portfolio to Very Dangerous-rated stocks.

Figure 3: Funds with the Best & Worst Ratings – Top 5

     * MF designates Mutual Funds and ETF designates Exchange-Traded Funds

Sources:   New Constructs, LLC and company filings

Investors need to tread carefully when considering Financials funds. Only 1 of the 270 funds for the sector allocates enough value to Attractive-or-better-rated stocks to earn an Attractive overall rating. Figure 3 shows the rating landscape of all ETFs and mutual funds in the Financials sector.

Our Sector Roadmap report ranks all sectors and highlights those that offer the best investments.

Figure 4: Separating the Best Funds From the Worst

Sources:   New Constructs, LLC and company filings

Figure 5 lists our Predictive Fund Rating for the 5 largest and most popular Financials funds.

Figure 5: Five Largest Financials Funds

     * MF designates Mutual Funds and ETF designates Exchange-Traded Funds

* Analysis uses the top-ranked class for each fund

Sources:   New Constructs, LLC and company filings

The full list of Financials funds and our ratings on each fund is here.

Dis­clo­sure: I receive no com­pen­sa­tion to write about any spe­cific stock, sec­tor or theme.

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