3 Financial ETFs Set to Benefit From a Better Economy

An improving U.S. economic outlook and expectations for higher interest rates mean the prospects are bright for stocks in the financial sector. Some investors have been wary about financial service stocks in the wake of the 2008 global financial crisis and the subsequent regulation that hit this sector, but now it could be time for financial stocks to shine, experts say.

"I'm very bullish on financial stocks right now," says Jeff Reeves, author of "The Frugal Investor's Guide to Finding Great Stocks," who is based in Rockville, Maryland. "It's not just the better balance sheets but the cyclical nature of banks. As consumer credit trends improve and as the economy broadly picks up, lending and bank earnings will follow. Throw in the prospect of a higher rate environment lifting net interest margins, and it adds up to a good outlook for the sector," Reeves says.

For investors looking for bargains, the financial sector could be poised to deliver. Stocks in this group, which include a wide range of companies, from banks and brokerage firms to asset managers and insurance companies, are trading at very low price-to-earnings ratios, says Charles Sizemore, founder of Sizemore Capital Management, a fee-based registered investment advisory firm based in Dallas. "Remember that the historical earnings numbers are terrible due the profit implosion of 2008 and the weak recovery that followed. Banks were forced to raise capital and haven't done much in the way of real lending in years. So prices are low relative to earnings," Sizemore says.

Financial sector stocks currently show the second lowest P/E ratio out of all the sectors in the Standard & Poor's 500 index, according to gurufocus.com, a Plano, Texas-based financial news publishing company. The financial services sector P/E ratio is 15.50, versus 20.1 for the S&P 500. "For the value investors out there, I would say that financials are attractive," Sizemore says.

Within the financial sector, regional banks are a top pick based on expectations that the U.S. economy will continue to improve and interest rates will move higher, which will help support increased demand for lending, says Patrick J. O'Hare, chief market analyst at Chicago-based Briefing.com, a live market analysis company.

"As consumers get more confident about job security and people earn more, we should see loan demand pick up. It should play well for the prospects for financial services companies," O'Hare says.

Economists expect the Federal Reserve to increase its federal funds rate once or twice this year, which will encourage banks to follow suit with higher lending rates. "They are apt to raise those lending rates at a quicker rate than the rate they pay depositors, and that will boost their profitability," O'Hare says.

Another attractive feature of regional banks is the domestic nature of their business. "They are limited from some of the big-picture problems like a European debt crisis, and instead are focused plays on their regional economies that continue to improve," Reeves says.

Looking to capitalize on the improving trend for financial services companies? To avoid the risk of investing in a single stock, here are three exchange-traded funds favored by experts. ETFs hold a basket of securities and trade on exchanges like stocks.

SPDR S&P Regional Banking ETF (symbol: KRE). This fund includes holdings such as Sterling Bancorp, Texas Capital Bancshares Inc. and BOK Financial Corp. "KRE is a nice play for investors, as it relates to the U.S. economic outlook unfolding in a favorable manner," O'Hare says. The fund charges 0.35 percent in annual expenses.

Financial Select Sector SPDR ETF (XLF). This ETF offers investors broad exposure to the U.S. financial services sector, and Wells Fargo & Company is its top holding. Other holdings include JPMorgan Chase & Co., Berkshire Hathaway Inc. and Bank of America Corp. The ETF charges 0.15 percent in annual fees.

"As a one-stop shop, the Financial Select SPDR is a solid choice. It's a collection of the largest names in the financial sector, though you have a few names in there you might not normally expect, like Berkshire Hathaway. Still, if you're looking for exposure to the big banks, you'll find it here," Sizemore says.

iShares US Financial Services (IYG). Investors can gain exposure to banks, brokerages and asset managers through this fund. Its top holding is Wells Fargo, and the fund also invests in JPMorgan Chase & Co. and Citigroup. The fund charges 0.45 percent in annual fees.

"Financial services companies and regional banks are in a great position to capitalize on acceleration in U.S. economic activity," O'Hare says.

Investors should be choosy about their investments and take a look at ETF holdings to avoid overlap, he adds. "You wouldn't want to go out and buy all of these because often they have the same stocks in their portfolio. You have to take a look at the holdings and see what percentage is allocated to each holding," O'Hare says.