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This Financial Fund Is Heating Up

Talk of tax reform and regulatory relief is among the factors drawing investors to banks.

Grabbing cash from your bank’s ATM may not be exciting. But if you purchased financial stocks in recent months, you ought to be thrilled. Financial Select Sector SPDR (symbol XLF, $24), an exchange-traded fund that holds banks and other financial firms, has surged 20% since Election Day, crushing the 11% return of Standard & Poor’s 500-stock index. XLF is a member of the Kiplinger ETF 20, our favorite exchange-traded funds. (Prices and returns are through March 31).

Why such ardor for banks? Despite some setbacks for the Trump administration’s agenda, investors still expect Washington to enact tax cuts that will charge up the economy. Banks would be prime beneficiaries because they would likely make more loans as the economy strengthens. Bulls also argue that profit margins on those loans would increase as interest rates rise.The prospect of a friendlier regulatory climate is lifting spirits, too. Investors hope banks won’t have to hold as much capital in reserve against losses, freeing up cash to make more loans. Also on the wish list is a repeal of many regulations in the Dodd-Frank law. “If Washington gets out of the way, we should see strong bank earnings over the next two to three years,” says David Rainey, comanager of the Hennessy Focus Fund.

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But veteran bank analyst Richard Bove, with brokerage firm Rafferty Capital Markets, doesn’t think investors’ exuberance is warranted. He doesn’t expect Congress to enact major tax cuts that would kickstart economic growth, partially because they would send the deficit (and bond yields) soaring. Nor does he think Congress or regulators will push through rule changes that would help banks signi­ficantly (some regulators would prefer to tighten rules to prevent another financial collapse).

Bove also views higher rates as a double-edged sword. If rates rise too much, they could stifle demand for loans. Steeper rates would also lower the value of banks’ Treasury bond holdings and other capital reserves, he says. “It’s like they’re dropping pennies into the piggy bank with higher profit margins from loans, but nickels are falling out of the bottom because their assets are losing value,” he says.

We share these concerns. But if you own XLF, stick with it for now. The fund holds more than just commercial banks, including insurers, financial-services firms and investment banks. Handouts from Washington would help these firms, but they can flourish without more assistance. Investment banks, for instance, should see a pickup in underwriting fees as companies take advantage of high stock prices to issue more shares, says Bove.

We also like the ETF’s top holding: Berkshire Hathaway (BRK.B), run by Warren Buffett and accounting for 11% of the fund’s assets. Berkshire’s big insurance unit gives it a lot of financial exposure. But Berkshire overall is like a proxy for the economy, with stakes in everything from food products to railroads. No matter how the political winds blow in Washington, Berkshire should thrive.

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