Less than five years after toxic mortgage loans and risky trading practices brought some of the country’s largest banks and insurance companies to the brink of financial ruin, financial sector stocks are enjoying renewed popularity. Propelled by record industry profits and signs of an economic rebound, ETFs that cover industries such as banking, brokerage, insurance and diversified financial services rose over 30% for the year ending September 18, eclipsing the Standard & Poor’s 500 index by nearly 10 percentage points.

Those favoring the sector cite a number of reasons the recent turnaround is more than just a short-lived comeback. Once-struggling institutions such as Bank of America, AIG and Citigroup are in a stronger financial position than they’ve been in for years. The quality of loan portfolios has improved, bringing fewer losses. And an improving economy promises to boost borrowing by consumers and businesses.

Rising interest rates could also provide a backwind for banks and insurers. When rates rise, banks and other financial services companies stand to benefit through better returns on new bond investments and more lucrative profits from bond trading. As the yield curve steepens, the spread between the rate at which banks borrow and the higher rate they charge for loans widens, which increases profitability. Rising rates are one reason financials are expected to generate 11.8% earnings growth in 2013 compared to 6.2% growth for the broader index, according to S&P Capital IQ consensus data.

By some measures, financial stocks are still reasonably priced. Most financial sector ETFs are still well below their peak prices in 2007. Many bank stocks, which typically sell at about double book value (assets, including cash, less liabilities), are priced at just above book value or less.

“At this point, financials, particularly banks and insurers that benefit from rising rates, look better than most other parts of the market,” says Michael Gibbs, senior vice president and co-head of the equity advisory group at Raymond James. “Even though they are pricier than the beginning of the year, they could continue to outperform over the next six to 12 months.”

But the road to redemption the stocks have forged so far is likely to get bumpier. The recent increase in 10-year Treasury bond yields that helped spark the recent rally in financials could easily reverse if Europe’s continuing debt woes drive risk-weary investors back to the safety of Treasury securities. Rates could also drop if weak economic data prompts the Fed to rev up Treasury bond purchases again in order to keep rates low for borrowers. Persistently low interest rates are one reason the group’s momentum began to stall in the second half of the year.

While financials are often viewed as a good cyclical play in a recovering economy, questions remain about just how strong the current recovery really is. Lending activity, which hasn’t rebounded as strongly as many had hoped, could easily drop off if rates on mortgages and other loans rise and consumers rein in spending on houses, cars and other big-ticket items.

Bonnie Baha, a portfolio manager and head of the global developed credit group for mutual fund family DoubleLine, says rising rates could have a negative impact on insurance companies, which invest heavily in longer-duration fixed-income portfolios. “Over the longer term, rising rates will allow the insurers to invest policyholders’ money more profitably,” she says. “But in the short term, it can have a damaging effect on bond portfolios.”

So far, at least, the stock market doesn’t seem too concerned about the issue. Year to date through September 18, the iShares Dow Jones U.S. Insurance ETF (IAK) rose 34% compared to 23% for the S&P 500 index.

On the banking front, Baha sees headwinds from the threat of increased regulatory oversight. For many banks, trading and investments represent a huge source of revenue. But the Dodd-Frank Act and other legislative initiatives, which seek to impose restrictions on those activities to avoid another 2008-style catastrophe, could curtail or eliminate those profit centers.

“Implementation of Dodd-Frank keeps getting pushed off into the future,” she says. “But if regulators end up moving forward, it would have an enormous impact on activities that are currently very profitable, but that may no longer exist in the future.”

Such reform took a step closer to reality this summer as President Obama called for the speedier adoption of Dodd-Frank, which was passed back in 2010. The renewed push came soon after the announcement of burgeoning bank profits highlighted the industry’s ability to withstand increased capital requirements and other parts of regulatory reform that have already been put into place.

“My overall view on financials isn’t necessarily negative,” says Baha. “But I don’t think we have reason to expect to see the outsized profitability that we’ve seen in the recent past.”

At the least, the stocks could be due for a breather. “Finding bargains in the financials sector has become increasingly difficult, as valuations are less attractive following 18 months of solid outperformance,” cautioned the midyear outlook for the T. Rowe Price Financial Services fund. “We believe financial stocks could outperform the broader market in the second half of 2013, but the magnitude of any outperformance, if it occurs, is likely to be smaller than what we have recently seen.”

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Despite such warnings, this year’s rally shows that even a small increase in interest rates or glimmers of hope on the economic horizon can provide a huge backwind for the economically sensitive sector. Assuming the economy continues to improve, rising rates enhance profitability and legislative reform remains mired in Washington gridlock, it’s possible that the group could outperform the market for the rest of the year, and perhaps longer.

But given the outperformance of financials relative to the overall stock market since last year, selective buying is key. “Valuations aren’t incredibly inexpensive anymore,” says Gibbs. “So my preference would be to buy on pullbacks.”

ETF investors interested in zeroing in on financials have 48 sector-specific ETFs to choose from, according to the ETF Database (etfdb.com). Some of them are diversified among a variety of component industries such as commercial banks, insurance companies, REITs and consumer finance firms. Others zero in on more specific niches, such as regional banks or insurance companies.

Like the sector itself, the two largest diversified financial ETFs, Financial Select Sector SPDR (XLF) and Vanguard Financials (VFH), carry a hefty dose of volatility. According to Morningstar, the standard deviation over the last five years has been 30.53% for the SPDR product, 27.94% for the Vanguard offering—well above the comparatively tame 18.5% standard deviation for the Standard & Poor’s 500 index.

While the two ETFs have performed similarly, they have different index constructions. The SPDR ETF includes all financial stocks in the S&P 500 and is dominated by large-cap names such as Wells Fargo, Bank of America and J.P. Morgan. It’s fairly concentrated, with the top 10 holdings accounting for about half of its assets. Vanguard Financials follows a broader basket of over 500 names and has a larger presence in mid-cap stocks and regional banks.

Regional bank ETFs have been standout performers this year as higher profits and the potential for merger and acquisition activity continue to attract investors. Small and mid-cap names dominate the largest member of the group, the $2.1 billion SPDR S&P Regional Banking (KRE). With each of its 77 holdings accounting for between 0.19% and 2% of assets, it spreads its bets widely. The more concentrated iShares Dow Jones U.S. Regional Banks ETF (IAT) has $525 million in assets and skews toward the larger regional banks. Top positions U.S. Bancorp (19% of assets) and PNC Financial Services (11%) have a huge influence on returns.

In a recent report, S&P Capital IQ cited a number of positive trends for the insurance industry, including its ability to invest new money at higher rates if interest rates continue to rise, strategic acquisitions, cost-saving divestitures and premium hikes. “Although the sector has advanced sharply this year, in our opinion, on improving fundamentals, we think it has more upside,” the report noted.

The iShares Dow Jones U.S. Insurance ETF (IAK) and SPDR S&P Insurance (KIE) are two solid ETF choices here, according to the firm. The former offering has 48% of assets in property and casualty insurers and 35% in life insurers. The market-cap-weighted index focuses on 68 holdings, with a concentrated 60% of assets filling the top 10 slots. The SPDR S&P Insurance ETF is a modified equal-weighted index, so assets are spread broadly over its 47 holdings. Property and casualty insurers and life insurers account for 39% and 23% of assets, respectively.

Capital IQ has a less-favorable view of ETFs that focus on mortgage real estate investment trusts because they’d be hurt by rising rates, and their expense ratios are high. ETFs that track only on the highest dividend payers among financial stocks are also relatively unattractive, since many of their component stocks have a high risk profile and have been bid up by investors to unattractive levels.