IAI iShares US Broker Dealers and Securities Exchanges ETF

In the aftermath of the financial crisis of 2008, the government sought to put in a variety of rules in order to prevent such a collapse from ever happening again. At the center of this process was the Dodd-Frank regulations which came into being in 2010.

However, many of the key provisions of this law have yet to be drafted, such as the so-called ‘Volcker Rule’, which was in the Dodd-Frank bill, but has been going back and forth among regulators and financial entities since then. Finally, it appears as if the variety of financial regulators have agreed on a way forward with this rule, giving banks until July 2015 to meet the terms of the provision (see all the Financial ETFs here).

Volcker Rule in Focus

The new guidelines look to prevent traditional lending companies from engaging in proprietary trading and a variety of high risk activities with depositor money. The idea behind this being that if a prop desk crashes, it won’t bring down the whole bank and force the government to get involved in order to bailout innocent depositors.

The law will also require CEO attestation of the effectiveness of compliance programs so that traders cannot run rouge and blow up a trading system on their own. This was obviously a huge issue when JP Morgan faced some trouble from its ‘London Whale’ debacle, which could have easily taken down a smaller financial institution, a risk that this requirement is looking to reduce.

The move may also hit bank profits, while it could also curtail market making activities. Some also are concerned that regulators will not be able to tell the difference between some types of hedging and other types of lower risk bets which are actually reducing exposure levels, a potential unintended consequence of the new provisions.

The real key to the law will be the implementation and how deep the Volcker Rule concerns really go, and if it curtails bank profits. Either way, the following three financial ETFs look to be ones to watch in the months ahead, as they could be the most impacted by this new rule:

PowerShares KBW Bank Portfolio (KBWB)

The law is targeted right at the banking industry, seeking to separate deposits and perceived higher-risk trading activities. For this reason, any bank-focused ETF could be heavily impacted by the news, such as KBWB.

This PowerShares product tracks the KBW Bank Index, holding about 25 companies in its basket. The biggest weights include some of the most-likely impacted firms, such as C, BAC, and JPM, though smaller, regional banks are also included as well, though large caps make up 67% of the total assets (read Top Ranked Financial ETF in Focus).

Thanks to its large cap value focus, the fund does have a risk rating of ‘low’ so it shouldn’t be too volatile even if trading issues arise. Meanwhile, the fund does have a Zacks ETF Rank #2 (Buy), and with a 36% gain over the past year it has certainly seen a strong performance over the past 52 weeks, so hopefully Volcker Rule issues don’t derail this solid trend.

iShares US Broker-Dealers ETF (IAI)

If there are reduced trading levels, companies that are brokers and dealers of securities could see sluggish volumes. And with reduced volumes, revenues—and thereby profits—could slump for companies in this market segment thanks to the Volcker Rule.

This broker ETF looks to be impacted by the trend, holding just 22 stocks in its portfolio, and assigning big weights to companies like the IntercontinentalExchange Group (ICE), Goldman Sachs Group (GS), and Morgan Stanley (MS). Large caps make up about 50% of the fund, though IAI does have a solid small cap holding of close to 30% of the portfolio (see 3 Top Performing ETFs of November).

While this new rule is definitely a concern, the fund does have a Zacks ETF Rank #2 (Buy), meaning we are still looking for some outperformance from this product. This would continue the solid trend in this fund, as IAI has added over 60% in the past one year.

PowerShares Global Listed Private Equity ETF (PSP)

One of the bigger winners from this new rule could be the private equity market. That is because, since they don’t have deposits, they could corner the prop trading market to an extent, and potentially maintain a stranglehold on the top talent as well.

PSP is an excellent way to play this segment, holding over 60 private equity firms that comprise the Global Listed Private Equity Index. Top holdings here include Blackstone Group (BX), Onex (OCX), and KKR & Co LP (KKR).

This PowerShares product has also seen a solid performance over the past year—though nothing compared to IAI—adding about 24% in the time frame. The stock also has a pretty solid 30-Day SEC Yield of 2.65% so it could be a good choice for income investors as well (see 3 High Quality Dividend ETFs to Buy This Holiday Season).

Bottom Line

The Volcker Rule could have a modest sized impact on financial securities, as it may reduce trading or make some firms more skittish about making big bets. This may curtail profitability for some, or funnel all the big trades into smaller firms that do not have depositor exposure.

It remains to be seen how devastating this rule will be on financial companies though, and only time will tell if it greatly curtails big banks and their broad activities. However, the aforementioned three ETFs could be great barometers of this rule’s impact on the financial system, and how investors may want to position their allocations in this new environment.

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