Big Banks Vs. Regionals: Polarizing Performances

September 02, 2009

The ETFs available to slice-and-dice banking sectors offer a glimpse into how much diversity, size and scope are impacting returns.


This week, financial stocks of all types are sliding on fears of more failures in the banking industry. But shares in major lenders remain dramatically improved from last year’s horrid returns.

Consider that Morgan Stanley, after losing nearly 68% in 2008, has returned more than 70% so far this year. Meanwhile, Goldman Sachs has risen some 90%-plus. And even laggard Citigroup, down more than 30%, staged a giant rally in August.

But while the bulge-bracket banks have boomed, local and regional banks have been depressed by a spate of bankruptcies of small financial institutions that has so far led to 106 bank closures in the U.S. Market watchers expect still more to come: Meredith Whitney, a prominent analyst, recently pointed out that the number could be nearer 200 once the Fed’s cleansing of the financial system has fully taken effect.

Big Bank, Small Bank Polarities

The polarization between the performance of large and small financial institutions has been felt acutely in the ETF arena, where many investors and advisers have used the products to hedge against long stock positions.

For example, while the SPDR KBW Regional Banking (NYSEArca: KRE), an ETF which tracks local banks, has dropped more than 26% year-to-date, in the same time frame the Financial Select Sector SPDR (NYSE Arca: XLF), which is invested in larger firms, is up by double-digits.

Broadly, asset managers have been using KRE to hedge their long positions in larger banks such as Citigroup. So far this year, they’ve been making money on both trades. Even in the case of better-performing regional bank ETFs, the buy-big, sell-small hedge has paid-off.

Regional Bank HOLDRs (NYSEArca: RKH) and SPDR KBW Bank (NYSEArca: KBE), two local bank ETFs, have risen only marginally in 2009.

With around 5% of banks and thrifts on regulators' watch lists, according to the latest Federal Deposit Insurance Corporation and Office of Thrift Supervision data, for now not many see much upside potential in investing in local banks.

Still, with so many financial ETFs available now, there may be some hidden gems lying among the rubble. Understanding the ETFs components is key.

Is Diversified Best?

Ironically, given today’s historically high volatility of the sector, part of the problem for financial ETFs is not only in their chosen areas of focus, but in their design as diversified products. Those that are least diversified have been performing more consistently than their more conservative counterparts.

KRE is the ultimate in diversified single-sector ETFs: just 27% of the fund’s capitalization is invested in its top 10 holdings. Compared with other financial ETFs, that’s pretty miniscule: First Trust Nasdaq ABA Community Bank Index Fund (NASDAQ: QABA), another small and regional bank ETF, concentrates 36% of its capital among its top ten positions. RKH and KBE are pretty nearly entirely invested in just ten banks, with more than 80% of their net asset values (NAVs) linked to their top ten holdings.


In terms of ETFs focused on large banks, ProShares Ultra Financials (NYSE Arca: UYG), is similarly focused to QABA, with 37% of its net asset value tied to 10 banks.  And at 56%, more than half of XLF’s capital is invested in the fund’s top ten positions: JP Morgan Chase and Bank of America alone make up more than a quarter of the fund’s NAV.

The co-relationship between investment concentration and alpha (or lack of it) is clear when you look at these products’ year-to-date performance. Since March 9, UYG had surged roughly 385% in value, while RKH and KBE had more than doubled heading into this week.

Getting The Right Local Bank Exposure

For an investor serious about investing in the regional banking sector, taking a closer look at the different ETFs’ holdings is crucial however.

For despite their relatively strong gains, some supposedly regional bank ETFs are in fact substantially invested in larger national banks – in particular JP Morgan and Bank of America. For example, 29% of RKH’s NAV is tied to both these firms; in the case of KBE 17% of the fund’s capital is invested in the two big banks. Many investors would not call that a truly accurate representation of the regional banking sector.

KRE and QABA are two of the ETFs most representative of the regional banking sector, and both have different investment focuses. While both funds invest in local savings and loans-style banks, QABA is heavily invested in North Eastern firms People’s United Financial and TFS Financial, as well as a spate of Missouri/Kansas banks such as BOK Financial. In other words, if the real estate market shows signs of a prolonged firming-up, QABA, launched only in July, could leap.

KRE is more diversified. Although that diversification means that the fund’s recent big wins, such as Wintrust Financial Corporation, impact the ETF less, for investors who are still wary about the regional banking sector as a whole KRE represents a good defensive investment.

If investors want to pair regional and national banking ETF exposure, now might also be the time to consider a short position in XLF, too. At the end of August, options traders were buying 2.7 put contracts for every one call contract, pushing the implied option volatility down to 34, from a 26-week average of 53. On the other hand, the highest volume of all KRE options contracts for September are the calls with a strike price of 25, indicating a lot of interest in a quick 20% upward price movement.

In other words, options investors are betting that some of the ultra-concentrated focus among the financial ETFs is about to get a little unstuck.


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