ETF Overview
Vanguard Financials Index Fund ETF (NYSEARCA:VFH) owns a portfolio of nearly 400 U.S. financial stocks. The fund has underperformed the S&P 500 index since its inception back in 2004. Stocks in its portfolio have a slower growth profile than the broader market, namely the S&P 500 index. Therefore, VFH is expected to continue to underperform the broader market in the future. The fund also has a higher downside risk than the S&P 500 index. Given the increasing possibility of a recession coming due to persistent inflation and the Federal Reserve’s policy to keep the rate elevated, we think investors may want to wait on the sidelines.
Fund Analysis
VFH has underperformed the broader market in the past
Let us first examine how VFH performed in the past. As can be seen from the chart below, since its inception in January 2004, VFH has generated a price return of 95.9% and a total return of 202.2% (including dividends) over the span of about 2 decades. While 200% return may sound like a lot, this return is not that good especially if we compare it with the broader market and many other sectors. As the chart below also shows, S&P 500 index generated a price return of about 338.6% and a total return of 545.6% including dividends. These returns are much better than VFH’s return. Other sectors such as utilities sector generated better returns. For example, Vanguard Utilities ETF (VPU) generated a total return over 460% in the same period, much higher than VFH.
VFH may continue to underperform in the future
Since we cannot control what happened in the past, we can look forward to the future. The question is whether VFH will have any chance to outperform the broader market in the future. To answer this question, let us take a look at the chart below. This chart shows the consensus long-term earnings growth (LTEG) and short-term earnings growth (STEG) estimates of all financial stocks in the S&P 500 index. For reader’s information, STEG is one-year ahead consensus expected short-term earnings growth and LTEG is 5-year ahead consensus expected long-term earnings growth. As the chart below shows, the consensus LTEG as of April 26 is about 10.8%. This means that the average earnings growth estimates for each of the next 5 years for these financial stocks is about 10.8% annually. This number appears to be consistent to the average annual growth rate since 1996.
Let us now look at the next chart, which shows the consensus earnings growth estimates of the S&P 500 index. As the chart below shows, the consensus LTEG as of April 26 is about 15.8%. This is much higher than the consensus 10.8% LTEG of financial stocks, as illustrated in the previous chart. Therefore, we think the return of the S&P 500 index will likely continue to outperform financial stocks in the next few years.
VFH has higher downside risk than the S&P 500 index
Let us now evaluate VFH’s downside risk in times of turmoil. Since VFH’s inception was back in January 2004, we have about 20 years of past records to examine. This means that we can examine how VFH performed during the recession in 2007/2008 and 2020. The chart below shows the price percentage off high for VFH and the S&P 500 index since 2005. As the chart below shows, VFH has declined more than 75% in the great recession in 2007/2008. In contrast, the S&P 500 index has declined by less than 60%. In the recession caused by COVID-19 in 2020, VFH has also declined more than the S&P 500 index.
Should you own VFH in this environment?
We continue to believe that the Federal Reserve will have no choice but to continue to keep its rate elevated for the rest of 2024 due to persistent inflation. As we know, persistent inflation can become a self-fulfilling prophecy. If consumers think products and services are going to get more expensive, they will tend to spend ahead, and this may result in higher demand and cause prices to go up. Therefore, there is still a long way for the Federal Reserve to bring inflation down to its 2~2.5% target. The longer the Federal Reserve must keep its rate elevated, the chance for a soft-landing diminishes. In other words, a recession may be inevitable. As we have shown in our previous section, VFH will likely have higher downside risk than the broader market. Therefore, the risk reward profile is not particularly attractive.
Investor Takeaway
We do not think VFH is a good long-term investment target if your investment goal is to optimize your total return in the long run. It also has higher downside risk than the broader market. Given that we may soon head for an economic recession, we suggest investors to wait on the sidelines.
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