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

 

This universe is defined by the Industry Classification Benchmark (ICB), which is the classification system designed by Dow Jones and FTSE, which is now solely owned by FTSE. This distinction may seem trivial, but it’s germane, because ICB differs from the classification system used by KRE: the Global Industry Classification Standard (GICS).

Each classification system begins with 10 headline sectors (or in the case of ICB, industries) and, like a family tree, branches out to more specific industries (sectors) and subindustries (subsectors). Unlike GICS, ICB does not have a regional banking subgroup, or at least not one that is publicly available.

This means that IAT’s universe is determined simply by relative market cap: Any firm that accounts for more than 5 percent of ICB’s U.S. banking sector is ineligible. For example, U.S. Bancorp gets a near 20 percent weighting in IAT even though it’s hard to argue that U.S. Bancorp is a regional bank.

KRE, on the other hand, equal-weights the regional banking firms it holds. That means PNC, which gets an 11 percent weighting in IAT, accounts for just 1.7 percent of KRE’s 79 holdings. It also means KRE has a significantly smaller market-cap profile than IAT.

The weighted average market cap of KRE is just $4.6 billion versus $25.5 billion for IAT. To add more color, 56 percent of IAT is invested in large-cap banks (greater than $12 billion market cap), while 90 percent of KRE is in small- and midcap banks.

In addition, KRE uses a business-focused model to classify regional banks:

Commercial banks whose businesses are derived primarily from conventional banking operations and have significant business activity in retail banking and small and medium corporate lending. Regional banks tend to operate in limited geographic regions. Excludes companies classified in the Diversified Banks and Thrifts & Mortgage Banks sub-industries. Also excludes investment banks classified in the Investment Banking & Brokerage Sub-Industry.”

This, combined with the drastically different profile of KRE’s portfolio, makes the two distinctly different takes on the regional banking market. I am in no position to say which approach is superior, but I do know that the 14 bp difference in round-trip costs between the two funds pales in comparison with the difference in exposure.

As a passive investing flag bearer, I tend to gravitate to cap-weighted funds, but in this case, the more rigorous classification process used by KRE aligns better with my sector investing sensibilities. As a soccer (football) fan, I’m comfortable calling this a draw.


At the time this article was written, the author held no position in the securities mentioned. Contact Paul Baiocchi at [email protected].


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