Choosing A Regional Banking ETF

February 06, 2014

Traditional depository institutions are the way to play rising rates, but which ETFs are the best way to invest in them?

Although long-term interest rates have been falling of late, the general consensus is that it’s only a matter of time before they start to rise. Should they rise, and short-term rates remain low (tapering is not tightening, we’re told) companies effecting the most basic financial transactions—borrowing short and lending long—should stand to benefit most.

These simple lending institutions benefit when the spread between short- and long-term interest rates widens or, said another way, when the yield curve steepens.

Given that the money center banks in this country are no longer akin to classic lending institutions but are rather complex financial conglomerates with their fingers in the waters of many different activities, they don’t really qualify.

All of which is why some, including the members of my macro panel at this year’s Inside ETFs conference, have pointed to regional banks as the way to play this dynamic. It’s precisely these simple banking firms that are still primarily focused on loaning people and businesses money.

This subset of the U.S. banking industry is similarly top-heavy in nature—the top 10 banks in a cap-weighted index of regional banks account for 63 percent of the market, with the top two banks accounting for more than 30 percent of total market capitalization.

Still, the weighted average market cap of these firms is just $25 billion compared with roughly $140 billion for the broader U.S. banking segment. That means any portfolio focused on regional banks is decidedly more small and midcap in nature.

There are currently three regional banking ETFs on the market, but only two of them—the SPDR S&P Regional Banking ETF (KRE | A-38, Opportunities List) and the iShares Dow Jones U.S. Regional Banks ETF (IAT | B-46)—have enough assets to make them practical trading tools.

Although both funds target regional banking firms, that is where the similarities end. KRE charges 0.35 percent a year, while IAT charges 0.46 percent. KRE has roughly $2.5 billion, while IAT has just under $450 million. More than $100 million worth of KRE trades most days at 3 bp spreads, while IAT gets less than $5 million in volume most days, and its average spread is 6 bps.

But more important than those cost and liquidity differences is the contrast between the approaches each takes to the market. IAT is your classic passive approach to the market: It weights and selects its holdings by market cap, meaning the biggest firms in its universe get the biggest weighting.

KRE vs IAT

Chart courtesy of StockCharts.com

 

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